1031 Exchanges: What Real Estate Investors Should Know Before They Sell

For many real estate investors, one of the biggest obstacles to selling an appreciated property isn’t finding a buyer.

It’s the tax consequences of selling.

An investor may have owned a rental house, apartment building, commercial property, or other investment real estate for years—or even decades. Commercial Real Estate Loans Archives – Steven Hook, San Francisco Mortgage Advisor

During that time, the property may have appreciated substantially while depreciation deductions have reduced the owner’s tax basis.

Selling can therefore potentially create a significant taxable gain.

That’s where a Section 1031 Like-Kind Exchange can become an important part of an investor’s real estate strategy.

A properly structured 1031 exchange may allow an investor to sell qualifying investment or business real estate and acquire replacement real estate while deferring federal capital gains taxes that otherwise might be due from the sale.

The key word, however, is properly.

1031 exchanges have strict rules, deadlines, and procedures. Financing the replacement property can also add another layer of complexity.

For that reason, investors should begin planning their exchange before they close the sale of their existing property—not afterward.

What Is a 1031 Exchange?

Section 1031 of the Internal Revenue Code generally allows qualifying real property held for investment or productive use in a trade or business to be exchanged for other qualifying real property.

Rather than receiving the sale proceeds and then purchasing another investment, a Qualified Intermediary (QI) generally holds the exchange proceeds between the two transactions.

This is extremely important.

Need a Qualified Intermediary? Visit my Recommended Resources page.

Will Gehl | Fidelis 1031 Exchange

If the investor receives or takes control of the proceeds, the transaction may no longer qualify as a 1031 exchange.

Another important requirement is taxpayer consistency. Generally, the taxpayer selling the relinquished property must be the same taxpayer acquiring the replacement property.

1031 Exchanges Aren’t Just for Commercial Real Estate

Some investors associate 1031 exchanges primarily with apartment buildings, office properties or other commercial investments.

But Section 1031 can apply to many forms of qualifying investment real estate.

Depending upon the circumstances, that might include:

• A single-family rental property
• A condominium held as a rental
• A 2–4 unit residential investment property
• An apartment building
• Retail property
• Office property
• Industrial property
• Land held for investment
• Other qualifying real estate held for investment or business use

Investor Real Estate Loans Archives – Steven Hook, San Francisco Mortgage Advisor

This is one reason residential real estate investors should understand 1031 exchanges just as much as commercial property investors.

The critical issue is generally how the real estate is held and used, rather than simply whether someone describes it as residential or commercial.

Primary residences and property held primarily for resale generally don’t qualify under the standard Section 1031 rules.

The Two Deadlines Every Investor Should Know

Once the relinquished property closes, the clock starts running.

The 45-Day Identification Deadline

The investor generally has 45 days to identify potential replacement property.

The identification must be in writing, signed by the taxpayer, and properly delivered to the Qualified Intermediary or another permitted party.

This deadline can arrive surprisingly quickly—particularly in competitive real estate markets.

The 180-Day Completion Deadline

The replacement property generally must be acquired within 180 days of selling the relinquished property.

There can be an earlier deadline associated with the taxpayer’s tax-return due date, which is one reason investors should coordinate with their CPA, tax attorney and Qualified Intermediary.

These aren’t casual target dates.

They are fundamental deadlines in the exchange process.

How Many Replacement Properties Can You Identify?

There are several identification methods.

The 3-Property Rule

An investor may identify up to three potential replacement properties without regard to their aggregate value.

This is the most commonly used approach.

The 200% Rule

An investor may identify more than three properties as long as the combined fair market value of the identified properties doesn’t exceed 200% of the fair market value of the relinquished property.

The 95% Rule

An investor can potentially identify an unlimited number of properties, but must ultimately acquire at least 95% of the total fair market value of the properties identified.

Because of the significant acquisition requirement, this rule is generally used much less frequently.

What Is “Boot” in a 1031 Exchange?

One of the common misconceptions about a 1031 exchange is that an investor simply has to buy another property.

It’s more complicated than that.

An investor may receive what’s commonly called boot, which can potentially create taxable gain.

Examples can include cash that isn’t reinvested and certain reductions in mortgage debt.

For example, an investor who sells a property and doesn’t reinvest all of the available exchange proceeds may create cash boot.

Debt also matters.

If the investor is relieved of debt on the property being sold and doesn’t adequately replace that debt—or otherwise structure the transaction appropriately—the investor could potentially create mortgage boot.

This is one of the areas where tax planning and mortgage planning need to work together.

The Financing Side of a 1031 Exchange

This is where I often become involved.

The tax rules may determine what the investor needs to accomplish, but the replacement property’s financing determines whether the investor can actually complete the acquisition.

And remember: the 180-day exchange clock doesn’t stop because a lender is taking longer than expected.

Before selling the relinquished property, I recommend investors begin discussing questions such as:

How much financing will be needed on the replacement property?

What type of property might they acquire?

Will conventional residential, commercial, bank portfolio, DSCR, bridge, SBA or another financing structure be appropriate?

How quickly can the financing realistically close?

What documentation will the lender require?

Could the investor’s income, liquidity, property type or ownership structure create underwriting issues?

Waiting until Day 45 to begin thinking about financing can unnecessarily increase the risk of an already time-sensitive transaction.

Not Every Replacement Property Fits the Same Lending Box

This is particularly important for investors moving from one type of real estate into another.

For example, someone might sell a residential rental and acquire a small apartment building.

Another investor might sell an apartment building and purchase commercial real estate.

An investor might exchange one larger property for several smaller properties—or consolidate several investments into a different asset.

The 1031 exchange and the financing therefore need to be evaluated together.

A replacement property that makes sense from an investment and tax perspective still needs to qualify for the appropriate financing.

Forward, Reverse and Improvement Exchanges

The traditional 1031 transaction is a forward exchange:

Sell first → purchase replacement property afterward.

But other structures are possible.

Reverse Exchange

What happens if the ideal replacement property becomes available before the investor can sell the existing property?

A reverse exchange may allow the replacement property to be acquired first. An Exchange Accommodation Titleholder (EAT) generally holds or “parks” the appropriate property while the exchange is completed.

Reverse exchanges are more complex, but they can be extremely valuable when an investor doesn’t want to lose an attractive acquisition opportunity.

Improvement or Build-to-Suit Exchange

An improvement exchange may allow exchange funds to be used toward qualifying improvements to replacement property while an EAT holds title during the exchange period.

Again, these transactions require careful advance planning and professional guidance.

One of the Biggest 1031 Mistakes: Touching the Money

An investor generally should not receive the exchange proceeds personally.

The Qualified Intermediary holds the funds between the sale of the relinquished property and acquisition of the replacement property in order to preserve the exchange structure.

This is why contacting the QI before the sale closes is so important.

Calling a Qualified Intermediary after the money has already been distributed to the seller may be too late.

A 1031 Exchange Is a Team Transaction

A successful exchange may involve several professionals:

Qualified Intermediary — Structures and facilitates the exchange and holds the exchange funds.

CPA or Tax Advisor — Evaluates the investor’s tax consequences, basis, depreciation, potential taxable gain and overall tax strategy.

Real Estate Attorney — Advises on legal and ownership issues when necessary.

Real Estate Agent or Broker — Helps sell the relinquished property and locate suitable replacement property.

Mortgage Broker/Lender — Determines how the replacement property can be financed and works toward meeting the exchange closing deadline.

These professionals have different roles.

My role as a mortgage broker isn’t to provide tax or legal advice. My job is to help make sure the financing strategy supports the investor’s overall real estate strategy.

Broker’s Edge Tip

Don’t wait until your investment property is in escrow to start planning your 1031 exchange.

Ideally, speak with your tax advisor, Qualified Intermediary and mortgage professional before the property being sold closes.

That gives everyone an opportunity to identify potential problems early—especially financing requirements that could affect which replacement properties you should consider.

In a transaction governed by 45-day and 180-day deadlines, time can become one of your most valuable assets.

Who Benefits Most From a 1031 Exchange?

A 1031 exchange may be worth discussing if you’re an investor who:

• Owns highly appreciated investment real estate
• Wants to reposition a real estate portfolio
• Wants to move from one geographic market to another
• Wants to exchange residential investment property for commercial property, or vice versa
• Wants to consolidate multiple properties
• Wants to diversify one investment into several properties
• Wants to move from a management-intensive property into a different investment
• Wants to continue investing in real estate rather than immediately recognizing the gain from a sale

Whether an exchange makes sense ultimately depends on the investor’s individual tax, investment and financial circumstances.

Common Misconception

“I have to exchange my property for the same kind of building.”

The term like-kind can be misleading.

For qualifying real property, it doesn’t necessarily mean exchanging an apartment building for another apartment building or a rental house for another rental house.

The rules can permit considerable flexibility among qualifying real estate held for investment or business purposes.

That’s another reason investors should explore their options before assuming a potential replacement property won’t work.

Questions to Ask Before Starting a 1031 Exchange

Before selling, consider asking your professional team:

• Does my existing property qualify for Section 1031 treatment?
• How much taxable gain might I have without an exchange?
• How much of my proceeds need to be reinvested?
• How will the debt on my existing property affect the exchange?
• How much financing will I need for the replacement property?
• What properties can I realistically finance?
• Should I consider more than one replacement property?
• When should the Qualified Intermediary become involved?
• What happens if I find my replacement property before selling?
• Do I need a reverse or improvement exchange?
• How quickly can my replacement-property financing close?

Key Takeaways

A 1031 exchange can be one of the most useful tools available to real estate investors, but it isn’t something to improvise after a property has already been sold.

Remember:

45 days to identify replacement property.

180 days to complete the exchange, subject to applicable tax-return timing rules.

A Qualified Intermediary generally needs to control the exchange proceeds.

The rules can apply to both residential and commercial investment real estate.

And the financing strategy should be considered before the exchange begins, not after you’ve identified a replacement property.

Planning a 1031 Exchange?

If you’re considering selling investment real estate and purchasing replacement property, I’m happy to discuss the financing side of the transaction before you sell.

For investors who need a Qualified Intermediary, I also maintain a Recommended Resources page with professionals I know and can refer you to, including Will at Fidelis 1031 Exchange.

Will Gehl | Fidelis 1031 Exchange

Bringing your mortgage professional, Qualified Intermediary and tax advisor together early can help you determine whether the real estate you want to acquire—and the financing needed to acquire it—fit your overall exchange strategy.

This article is for educational purposes only and isn’t intended as tax or legal advice. Section 1031 rules are complex and may change. Investors should consult a qualified tax advisor, attorney and Qualified Intermediary regarding their individual transaction.