Also known as a Starker Exchange or Like-Kind Exchange
How to do a 1031 exchange
Exchanging one investment property for another
In simple terms, the 1031 exchange strategy allows an investor the ability to defer paying capital gains taxes on investment property when it’s sold, if another like-kind property is purchased with the profit gained by the sale of the first property.
A 1031 (tax code) exchange is a powerful tax-deferment strategy used by some of the most finically successful investors. Many investors across the country believe that today is a great time to exchange properties in expensive markets for cash flow type properties. In effect, you can change the form of your investment without cashing out or recognizing a capital gain.
Types of exchanges:
Simultaneous Exchange
The simultaneous exchange occurs when the replacement property and the relinquished property close on the same day.
Delayed Exchange
A delayed exchange is the most common type of exchange and occurs when the exchanger relinquishes the original property before acquiring the replacement property.
Construction / Improvement Exchange
This exchange allows a taxpayer to make improvements on the replacement property by using the exchange equity.
Steps:
Hire a 1031 exchange facilitator
Compile information on the exiting property (property you are eliminating)
- What kind of property is it?
- When was the property purchased?
- What was the purchase price?
- How is the property held or vested?
- What is the mortgage balance and equity position of the property?
- How was the property used?
- What is currently in escrow?
- What is the closing date?
Compile information on the replacement property
- What kind of property is it?
- What will be the purchase price, down payment and loan amount?
- If applicable, who is the escrow company?
1031 Terminology to Know:
- Qualified Intermediary: A party that facilitates the documentation for the exchange and holds the funds from the sale of the relinquished property pursuant to IRC Section 1031. Also known as QI, facilitator, accommodator.
- Exchanger: The party that is benefiting from tax deferral through IRC Section 1031. Also known as the taxpayer or investor.
- Relinquished Property: The property being sold by the taxpayer in a 1031 exchange. Also known as Phase1 or Downleg.
- Replacement Property: The property being purchased by the taxpayer in a 1031 exchange. Also known as Phase 2 or Upleg.
- Delayed Exchange: An exchange where the closing of the relinquished property can occur up to 180 days after the closing of the replacement property.
- Boot: Receiving property that is not considered “like-kind” which includes cash or non-cash consideration, debt relief (mortgage boot), or promissory notes. If you receive boot in an exchange it is likely that all or some portion of the boot will be taxed.
- Exchange Period: The period of time between the relinquished property closing and acquisition of the replacement property. The Exchange Period ends on a date that is 180 days after the relinquished property closes, or the due date on which the tax return is due for the year the relinquished property was sold, if that is sooner. For exchanges closing in the final quarter of the year, the taxpayer will need to file an extension of the filing of their return to have the full 180-day time frame.
- Identification Period: The 45-day timeframe after the transfer of the relinquished property in which the taxpayer must identify in writing replacement properties. Proper identification of replacement property is a requirement for a valid exchange and the investor can only acquire property which has been properly identified during the 45-day identification period.
- Like-Kind Property: In the context of real estate, like-kind exchanges are valid between and among several different types of investment property, including bare land, commercial property, industrial buildings, retail stores, apartments, residential rentals, even leasehold interests exceeding 30 years. Personal property exchanges are much more restrictive than real property exchanges with regard to the interpretation of like kind.
- Basis: The starting point for determining gain or loss in any transaction. In general, basis is the cost of the taxpayer’s property, plus capital improvements less depreciation.
We have used this process when a seller wishes to exchange “his equity” from the real estate value portion of his business sale into an investment real estate project that gives him/her steady long-term rental income without paying capital gains on the state part of the business.
