As commercial brokers, it is part of our job to help our clients make the best real estate decisions that are appropriate for their situation. One of the tools available for doing that with commercial real estate investors is a 1031 exchange, also known as a like-kind exchange. While this tool isn’t for everyone, it is one of the strategies that we often get asked about. For anyone interested in real estate investing, it’s worth having at least a working knowledge of what a 1031 exchange is and what its potential benefits are.

Disclaimer

The information included in this article is for general educational and informational purposes only. For advice and guidance on potential legal and tax implications regarding a 1031 exchange, be sure to consult with a trusted real estate tax advisor and attorney as part of your team of commercial real estate professionals.

What is a 1031 Exchange?

According to Pickett Sprouse Commercial Real Estate Broker Brad Gregory, “A 1031 exchange allows you to defer capital gains tax when you sell an investment property and reinvest the proceeds from the sale in a property or properties of like kind and equal or greater value.” It is named after Section 1031 of the Internal Revenue Code and basically means that there’s nothing to be taxed if the profit from the sale is immediately invested into another piece of real property that is held for productive use by a business or as an investment property.

Understanding the Basics of a 1031 Exchange

Before we get into the details of how the 1031 exchange process works, there are several key terms and rules that you should be familiar with.

Relinquished property

The property that you want to sell is known as the relinquished property.

Like-kind property

According to the Internal Revenue Service (IRS), "Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality." Matt Linville, Vice President of Marketing for Chapel Hill-based Investors Title Exchange Corporation explains, "There is a great deal of flexibility because the definition is so broad." While this means that you can always exchange an apartment building for another apartment building, it also means you can exchange an apartment building for an office building or raw land for a rental house. What you can't do, though, is exchange the property for personal property such as a car or a residential home that won't be used for business or investment purposes.

Up to 3 replacement properties can be identified

When the seller is identifying a replacement property for the one sold, they can identify up to three. Matt says, "It certainly doesn't hurt to have additional properties identified so that just in case you can't close on property B like you wanted, you have properties C and D that are your backups that you could default to if needed." If more than three properties are identified, the total value of all of the identified properties cannot exceed 200% of the relinquished property’s sales price.

It's important to note that if only one property is identified, and that falls through for any reason and backups aren't officially identified, the 1031 exchange will not be able to take place. That being said, just because replacement properties have been identified, there isn't anything that obligates you to go through with purchasing one of those properties if you decide you don't want to. However, once the funds are in the QI’s hands, strict IRS rules apply as to when your remaining funds can be returned to you. You may have to wait until the end of the 180-day exchange period to receive your money.

Timing is everything

There are two crucial timing considerations that must be kept in mind in order to qualify for a 1031 exchange. Matt explains what those are and that the clock for both begins ticking at closing for the property that's being sold.

45 days to identify new property: During this time, the IRS allows you to identify a potential replacement property.
180 days to close on replacement property: You have 180 days from the sale of the original property or until your tax filing due date, whichever one is less, to close and take title of any or all of the properties you identified for the exchange.

Qualified Intermediary (QI)

If you want to do a 1031 exchange, you are required to have a qualified intermediary (QI) in place before you sell your property. A QI acts as an independent middleman to facilitate the 1031 exchange. They hold the proceeds from the sale of your property and use it to buy the replacement property for you. It's important that you do not receive the sale proceeds directly because this could disqualify the exchange. The QI also prepares the necessary paperwork and makes sure that the exchange rules are followed.

A QI cannot be someone who is related to you and can't have worked for you in any capacity during the previous two years before the sale of the property. That means they can't be your real estate agent, accountant, tax attorney, investment banker, or any other type of employee.

Personal property is excluded

The IRS emphasizes that the profit from the sale of a commercial property cannot be used to buy personal property. This means that you can't buy a property that you intend to live in and still avoid paying capital gains on the profits from the sale of the previous property. The profits from the sale of a property in a 1031 exchange must be used to buy another property for business or investment use.

Types of 1031 Exchanges

There are several types of 1031 exchanges that investors can utilize, depending on the situation and goals. Brad offers a simple breakdown of the main types.

Two-Party Simultaneous Exchange: This is when two property owners decide to trade places by swapping the deeds to their properties. This straight swap sounds straightforward but matching up properties of equal value can be tricky.
Delayed Exchange: This is the most common type. Here, you sell your property first, then you have 45 days to pick out a new one and up to 180 days to close the deal.
Reverse Exchange: In this scenario, you buy your replacement property before selling the old one. In this case, an Exchange Accommodation Titleholder (EAT) holds onto the title for the new or old property temporarily until the relinquished property can be deeded to a buyer.
Construction/Improvement Exchange: This option lets you use the money from your sale to improve your new property. You just have to make sure the final value matches or exceeds the value of the property you sold.

How a 1031 Exchange Works

Matt offers this explanation of how a 1031 exchange works for a client who owns a commercial building.

"When they look at selling that building, everything happens as normal. They still have a listing broker or agent, and they would sell that property. But, before they sold it and actually sat down at the table to close on it, they would also work with a qualified intermediary. The qualified intermediary's job is to be that independent third party that will actually receive proceeds from the sale of the property, hold those funds until the client is able to buy a replacement property, and those funds will be dispersed for the replacement property closing."

Step-by-step breakdown of the 1031 exchange process

Here's a step-by-step breakdown of the 1031 exchange process:

Notify CPA and real estate attorney about plans to do a 1031 exchange. You will want to get their input and advice about whether it makes sense with your particular situation before moving on to any other steps.
Before the relinquished property closing, the QI drafts the exchange documents.
At the relinquished property closing, the completed exchange documents transfer the deed for the property from you to the buyer. The closing attorney then sends the signed documents and net sales proceeds to the QI.
The QI holds funds from the sale of the property in an interest-bearing account.
You identify a replacement property and report it to the QI within 45 days after closing the sale.
Prior to the replacement property closing, the QI drafts replacement property documents, coordinates with closer, and sends funds for closing to closer.
At the replacement property closing, the replacement property documents authorize direct deeding of the property from the seller to you.

Common Concerns With Completing a 1031 Exchange

There are many moving parts that must be coordinated when dealing with a 1031 exchange. Matt notes that these are the most common.

Making sure the client has an exchange agreement in place with a qualified intermediary signed and dated by the time they get to the closing table. That sets the 1031 in motion.
The day that closing takes place, the two time clocks begin to tick. Those are the 45-day identification period and the 180 days to close on the replacement property.
Achieving a full tax deferral. "The IRS tells us that if you sell a property for $1 million, they want you to buy a property for at least $1 million to get a full tax deferral."
Same taxpayer rule. The entity that sells the property needs to be the entity that buys the property. "The IRS wants to make sure that the taxpayer stays in place because the tax is only being deferred, it's not being exempted."

Benefits of Using a 1031 Exchange

Matt points to several key benefits for using a 1031 exchange.

Capital gains taxes are deferred.
Opportunity to reinvest the profit from the sale of a property back into real estate portfolio.
Good way to diversify into other types of property, which can help to spread out risk.
Property owners can sell out of an underperforming asset or non-income-producing property, like land, into a commercial or other type of income-producing property.

Possible Pitfalls of a 1031 Exchange

There are several possible pitfalls of a 1031 exchange. Matt offers a look at what some of those are.

There are strict rules and regulations. Any missteps or inaccuracies in the process could result in disqualification of the exchange and the investor paying capital gains taxes.
Tight timing constraints. The fact that investors must identify a replacement property within 45 days of the sale of the relinquished property and complete the exchange within 180 days can create pressure to find another property quickly. This may result in a less-than-ideal investment decision.
The requirement that the replacement property must be of equal or greater value than the relinquished property in order to defer all capital gains taxes. This can limit an investor's options and make it challenging to find a suitable replacement property that meets this requirement.

Choosing a Qualified Intermediary

When it comes to choosing a Qualified Intermediary for your 1031 exchange, there are several factors to consider to ensure a smooth and successful exchange process. Here's a simplified guide to help you make an informed decision:

Experience and Knowledge: Look for a QI with a strong background in real estate and 1031 exchanges. With all of the documents that have to be prepared and deadlines that have to be met, their experience can be a significant asset, especially in complex transactions.

Insurance and Funds Management: Ensure that your QI has proper insurance, including errors and omissions (E&O) insurance, to protect against potential mistakes or oversights. It's also crucial that they manage funds securely, holding them in a separate escrow account to safeguard your investment.

Costs, Fees, and Communication: Understand the costs and fees involved on the part of the QI, and choose a QI that prioritizes transparent communication. This is especially important as deadlines approach, so choose a QI who provides timely updates and support.

The Bottom Line on Understanding What is a 1031 Exchange in Real Estate

The goal of a 1031 exchange is to defer capital gains tax, not to avoid it altogether. If done correctly, and with the help of a qualified intermediary, such as Investors Title Exchange Corporation, you can reinvest the full amount of your sale into a new property, potentially leading to more significant investment growth over time.

If you're interested in a 1031 exchange, be sure to contact us at marketing@pickettsprouse.com for more information on how our brokers can guide you through the process.