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Four Concepts to Understanding a 1031 Exchange

An IRS Section 1031 tax deferred exchange is both a complex technique and a simple set of concepts.

The complexities of a 1031 exchange come from having to follow an intricate set of rules found in the IRS tax code and the regulations that further explain those rules. The simplicity of an exchange can be explained by reviewing a set of four basic concepts.

The premise of a 1031 exchange is based on “relinquishing” a property and acquiring a replacement property following a set of rules and guidelines provided by the IRS. Done correctly and following all the rules, a taxpayer may save payment of taxes.

The underpinnings of an exchange are based on the continuity of ownership interest in real property. That is, if a taxpayer sells or “relinquishes” a property and receives replacement property, following all required steps, the IRS will look at that sequence of transactions as if the taxpayer never really got rid of a property. It is as if he or she continued to own real estate the whole time. Here are details:

1. Tax Strategy – The major motivation of an investor in considering a 1031 exchange is to keep from paying capital gains taxes on the sale of an investment property. The current capital gains tax rate is 15% for long term gain (profit). While this rate seems low, there is more to the equation. For improved property (rental houses, commercial property, etc.) accumulated depreciation deductions must be recaptured and taxes will be due at a rate of 25%. Finally, there is a state level tax. In Georgia, the taxpayer will owe 6% on the profit (appreciation) as well as 6% on the depreciation recapture.

For example: Assume an investor purchased a rental house for $100,000, and held it for a number of years with total depreciation deductions of $40,000. If the property were to be sold for $200,000, the investor could have a tax liability of over $33,000.

2. Replacement property – To keep from paying $33,000 or more, the sale of the first rental property must be linked through specific documentation to the purchase of replacement property. In acquiring replacement property, the investor must comply with the basic premise that this tax code section applies to “property held for investment or for use in a trade or business”. Typically, the phrase "like kind" is used when describing replacement properties. Any kind of real estate would be considered like kind as long as it was held for investment.
3. Time requirements – The IRS provides two very specific time constraints for completing a 1031 exchange. From the day the relinquished property is sold, the investor has a total of 180 days to acquire replacement property. The 180-day replacement period is similar to the now repealed primary residence “2 year rollover rule” which allowed homeowners to defer gain on the sale of a residence if they bought a replacement within the prescribed time period.

The second and tougher rule to follow is the Identification Rule that requires investors to choose one or more replacement properties. These target properties must be listed in writing on a Target Identification Letter by the 45th day following the close of the first property. The target ID letter is held by the facilitator known as a “qualified intermediary” to comply with IRS requirements.

4. Equal or greater value – The last concept for a successful totally tax deferred exchange is acquiring property with a value equal or greater to the value of the property being sold. There are two components to this rule. First, all of the equity or cash from the first property must be “spent” on acquiring the replacement property or properties. Second, the total value of replacement property must equal or exceed the value of the relinquished property.

If there was mortgage on the first property, generally the equal or greater requirement simply means that the taxpayer will get a mortgage on the replacement property in an amount equal to or greater than the original debt.

In summary, the key concepts in a tax deferred exchange involve the following – (1) saving federal and possibly state capital gains taxes on the sale of investment property by (2) acquiring replacement property of a like kind within (3) a time period of 180 days after properly identifying replacement property within 45 days and (4) spending the equity forward on property of equal or greater value.

John Mangham, CPA