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The Complete Guide to 1031 Exchanges
by Mark Minassian, CPA

A 1031 exchange (also known as a like-kind exchange) is a transaction that allows a taxpayer to defer the capital gains tax that would be due on a sale of an asset. 1031 exchanges are almost exclusively used in real estate, but they can be used for other types of assets as well. A 1031 exchange allows real estate investors to defer the capital gains tax on the sale of appreciated property if they reinvest the proceeds in a new property. But while a 1031 exchange may sound simple in premise, there are specific rules that must be followed to completely defer the capital gains tax.

The rules governing 1031 exchanges are provided in Section 1031 of the Internal Revenue Code and have actually been around since the 1920s. A traditional 1031 exchange involves a simultaneous swap of your property with a like-kind property, but the rules governing traditional 1031 exchanges were complicated and the process was cumbersome. In 1979, the famous Starker decision by the U.S. Court of Appeals changed the face of the 1031 exchange. The Starker decision allowed a “deferred” exchange—that is selling your existing property first and then buying your replacement property. But even though the court ruled on the issue in 1979, it wasn’t until 1991 when the Treasury Regulations were amended to clarify and simplify the deferred exchange that this form of 1031 exchange became popular among real estate investors.

So when people talk about a 1031 exchange today, they are usually referring to a deferred exchange (also called a Starker exchange).

General Rules   •   The Deferred (Starker) Exchange   •   Boot   •   Special Exchanges   •   When Not to Use

The General Rules of the 1031 Exchange

  1. A 1031 exchange is a tax-deferred exchange, not a tax-free exchange. If you complete a 1031 exchange, you can defer the capital gains taxes on the sale of your existing property. However, if you later sell the replacement property, you will have to pay capital gains taxes (if you in fact have a capital gain). You may, of course, do a 1031 exchange with your replacement property and keep deferring your capital gains tax. The way to actually avoid the capital gains tax is to hold your replacement property until you die. Then your heirs will inherit your property at its fair market value and can sell it with no (or very little) capital gains taxes due.

  2. The property exchanged must be either held for investment or used in a trade or business. Thus your personal residence does not qualify for 1031 exchange treatment unless it was used in your business. However, under Section 121 of the Internal Revenue Code, you can exclude up to $250,000 (if single) or $500,000 (if married) of the gain on the sale of your personal residence if certain requirements are met.

  3. The property exchanged must be like-kind property. The IRS is very liberal in defining like-kind property of real estate. Almost, any type of real estate, improved or unimproved, can be exchanged for other real estate. The following types of properties are considered like-kind for 1031 exchange purposes:

    • A residential rental property and a commercial rental property
    • A shopping mall and an undeveloped piece of land
    • A condominium and a share of a cooperative
    • Permanent conservation easements in two different pieces of real estate
    • Water rights of unlimited duration and farmland

    However, the like-kind property must be in the 50 United States or the U.S. Virgin Islands. Foreign real estate is not considered like-kind property for the purposes of a 1031 exchange.

  4. Certain types of property do not qualify for 1031 exchanges. These include property held for personal use, inventory, partnership interests and stocks and bonds. Vacation homes may qualify under certain circumstances.

    TIP: Real estate investors who flip a lot of properties must be careful here. If you are classified as a real estate dealer for the properties that you own, those properties will be considered inventory and are not eligible for 1031 exchanges.

  5. The amount of capital gain that you defer will reduce the basis of your replacement property. Your depreciable basis of your replacement property will not equal the purchase price of the property because your basis will be reduced by the amount of gain that is deferred. If the adjusted basis of the property you are selling is low and your replacement property is not much higher in value, your basis of the replacement property will be almost identical to the basis of your old property.

    TIP: You must allocate the cost basis of your replacement property between the building and the land. If the property you are relinquishing includes a lot of land, you may want to consider buying a replacement property with less land. You will then be able to allocate more of the basis in the new property to the building. This can give you a bump up in your depreciable basis, especially if the adjusted basis on the property you are relinquishing is very low.

The Deferred (Starker) Exchange

A traditional 1031 exchange involves the simultaneous swap of your property for another property. The Starker exchange allows you to sell your property first and then buy your replacement property at a later date. This is by far the most common form of 1031 exchanges done today.

Specific rules must be followed to successfully complete a deferred exchange and defer all of the capital gains tax that would be due on the sale of your property.

  1. You must not have any access to the money from the sale of your property. The easiest and most effective way to accomplish this is by using a qualified intermediary (QI). You will sell your existing property and the money will go to the intermediary who will hold the funds in an escrow account. When you purchase your replacement (new) property, the QI will deliver the funds to the closing agent and the new property will be deeded over to you. The intermediary’s fee will vary depending on location and the number of properties involved, but they will generally charge between $300 and $700 for a deferred exchange.

    TIP: While using a QI is not mandatory to complete a deferred exchange, it is strongly recommended. Without one, you have to meet one of the IRS’ complicated safe harbor requirements to successfully complete your exchange.

  2. You must reinvest all of the proceeds from the sale of your property into the new property. If you do not, you will have to recognize a capital gain based on the amount of money not reinvested.

  3. Once you sell your existing property, you have 45 days to identify a replacement property. You may identify more than one replacement property, but if you do, you must comply with one of the following three rules:

    • 3-Property Rule – You may identify up to three replacement properties without regards to their value; OR
    • 200% Rule – You may identify as many properties as you want as long as the total value of all the properties does not exceed twice the value of the property you are relinquishing; OR
    • 95% Rule – You may identify as many properties as you want but the property (or properties) you eventually buy must have a value equal to at least 95% of all of the properties you identified. For example, if you identify five properties worth $1 million collectively, the property you end up buying must have a value of at least $950,000.

  4. The replacement property must be of equal or greater value to the property you are relinquishing. You must trade up in value or you will end up recognizing a capital gain for the decrease in value between your old property and new property.

    TIP: Since you will have fees involved in selling your property, such as brokers’ fees, intermediary fees and other closing costs, the purchase price of the replacement property should be equal to or greater than the total debt on the property you relinquish plus the net amount of money you receive from the sale of your property.

    In addition, the debt on the new property must be greater than the debt on the old property or the amount of equity in the new property must be greater than the equity in the old property. However, as long as you are trading up in property value and you invest all of the proceeds being held by the intermediary into the new property, the debt/equity requirement will take care of itself. That is because either the debt will be higher due to the higher purchase price of the new property or you will have to invest your own money (equity) in the new property to make up the difference.

  5. Once you sell your existing property, you must close on your new property within the earlier of 180 days or the due date of your tax return (including extensions). It is important to remember that the 45 day identification period runs concurrently with the 180 day closing period.

    Example: You sell your property on June 1st. You have until July 15th (45 days from June 1st) to identify your replacement property and you must close on the replacement property by November 27th (180 days from June 1st).

    TIP: If you enter into a deferred 1031 exchange and sell your property between October 1st and December 31st, be sure to file an extension for your individual tax return due on the following April 15th. Otherwise, your window to close on the new property may be reduced by as much as 2 1/2 months.

  6. The QI will contact the closing agent, complete the necessary exchange paperwork and transfer the funds to escrow for the purchase of your replacement property.

  7. When you file your tax return, you must report the exchange on IRS Form 8824, Like-Kind Exchanges.

There is no penalty if you change your mind about doing a 1031 exchange after engaging a QI or if you do not meet the 45/180 day requirements. The QI will return your money to you and you will be taxed on the sale of your property as if you had sold it outright. However, you will still have the pay the QI their fee.

Boot in a 1031 Exchange

The term “boot” refers to any non-like-kind property that is exchanged. The most common forms of boot are cash and mortgages. The general rule is that if you receive more boot than you give up, you will have to pay tax on the net amount of boot you receive.

Cash Boot

In a traditional 1031 exchange (i.e. a swap), it is difficult to find two properties that are of exact equal value. So to compensate, one party gives cash (boot) to the other to make up the difference. However, in a deferred exchange, since you are selling your property first and must reinvest all of the sale proceeds in the replacement property to fully defer the capital gains tax, you will generally not be receiving any cash boot. However, any portion of your sale proceeds that you do not reinvest in the replacement property will be considered cash boot to you and you will have to pay tax on that amount.

Mortgage Boot

Mortgage boot is very common with 1031 exchanges. If the property you are selling has a mortgage on it, the relief of the mortgage will be considered boot to you. So to make sure you do not pay taxes on that boot, you must either have a bigger mortgage on your replacement property than you did on your relinquished property or you must invest your own money in the new property to make up the difference in the purchase price.

The formula for determining boot received is as follows:

Mortgage on your property surrendered
- Mortgage on the property received
- Additional cash paid by you towards the new property *
= Net boot received (not less than zero)
+ Any cash received by you in the exchange
= Boot received

* This does not include the money invested in the new property from the sale of your old property

You will have a taxable gain to the extent of the boot received. The important thing to note here is that you will be taxed on any cash boot received regardless of how much other boot you paid.

Special Exchanges

In certain situations, additional guidelines need to be followed if the 1031 is to be completed successfully.

Construction of replacement property

It is possible to enter a deferred exchange where your replacement property has not been built yet. However, there are certain requirements that must be met to do this.

  • There must be another party involved who actually purchases the lot and contracts with the builder. If the other party simply acts as an agent to find you a builder and lot without actually taking title and then selling it to you, the exchange will not work
  • If construction is not completed and the property is not sold to you within the 180-day window, the exchange will not work
  • Even if the constructed property is sold to you within 180 days, any costs incurred by the other party or intermediary after 180 days will be considered boot to you which you will have to pay taxes on

Related party exchanges

Special rules apply for exchanges between related parties. A related party is a family member or a business entity or trust that you own more than 50% of.

The general rule regarding related party exchanges is that if you sell or otherwise dispose of your replacement property received from a related party within two years of the date the property was transferred to you, you will have to recognize the gain that you previously deferred. However, the two-year rule does not apply if any of the following exceptions are met:

  1. One of the parties dies within the two-year period
  2. The property is destroyed in a compulsory or involuntary conversion (such as a natural disaster)
  3. You prove to the IRS that the exchange and subsequent disposition of the property within two years was not done to avoid paying taxes

Reverse exchange

A reverse exchange (also known as a parking arrangement) occurs when you take title to your replacement property before you relinquish your property. In 1991, the IRS announced that the like-kind exchange rules did not apply to reverse exchanges. However, due to many questions and comments on the issue, in 2000 the IRS issued Revenue Procedure 2000-37 and provided safe harbor requirements that allow reverse exchanges to be treated as like-kind exchanges.

The IRS safe harbor requirements for reverse exchanges include the following:

  • An Exchange Accommodation Titleholder (EAT) must take title to the replacement property. The EAT will “park” the property until you sell your property.
  • Within five days from when the EAT takes title to the property, you must enter into a Qualified Exchange Accommodation Agreement (QEAA) with the EAT. The QEAA must specify the intentions of both parties and the rules that must be followed to complete the exchange.
  • You must identify the property you wish to relinquish within 45 days of signing the QEAA and you must close on the sale of your property within 180 days of signing the QEAA

However, real estate developers who owned multiple properties found a loophole in the reverse exchange rules. An individual would transfer a piece of land to an EAT and the EAT would contract for construction of a house or building on that land. The developer would then sell another property to a QI in a deferred 1031 exchange. They would then identify their replacement property (as part of the deferred 1031 exchange) as the newly constructed property being held by the EAT. Thus, they would end up replacing their relinquished property with a property they had previously owned while deferring the capital gain on the sale of the property they sold.

In 2004, the IRS issued Revenue Procedure 2004-51 to close this loophole. Rev. Proc. 2004-51 says that the safe harbor rules of Rev. Proc. 2000-37 will not apply if the replacement property was previously owned by the taxpayer within 180 days of the transfer to the EAT.

Vacation homes

There rules are ambiguous as to whether a vacation home will qualify for 1031 exchange treatment because the property must held for investment or for use in a trade or business.  If a vacation home is also a rental property it will qualify for a 1031 exchange. However, if a vacation has been primarily (or solely) held for personal use, it may be hard to prove that it is an investment property. A property is generally considered to be held for personal use if it is used by the owner for more than 14 days during the year or for more than 10% of the number of days the property was rented during the year at fair market value.

If you want to complete a 1031 exchange with a vacation home, certain precautions should be taken. You should both limit your personal use of the house and rent the property out at fair market value for at least one year before doing a 1031 exchange. The idea is to show that the property is held for investment purposes and is not merely a second home.

Converting a 1031 property into a personal residence

Another strategy that people previously employed was acquiring a rental property through a 1031 exchange, renting it out for a year or two, converting the property to their personal residence and selling it after two years and excluding the gain under the home sale exclusion rules.

The American Jobs Creation Act of 2004 closed this loophole by requiring property acquired in a 1031 exchange to be held for at least five years to qualify for the home sale exclusion. Thus, a taxpayer wishing to convert a 1031 property to a personal residence and exclude the gain under the home sale exclusion rules must hold the property for at least five years while living there for at least two of those five years. In addition, the property must be used as a rental (or shown to be an investment property) for a reasonable period of time (i.e. at least one year).

When Not to Use a 1031 Exchange

While the 1031 exchange can be a valuable tool for deferring the capital gains on the sale of your property, there are certain situations where an exchange would be less beneficial than an outright sale of your property, such as:

  1. The value of the property is less than your cost basis. A 1031 exchange in this situation would actually defer the loss on the sale of the property and prevent you from recognizing the loss in the year that it occurred.

  2. You have current year losses or loss carryovers (i.e. capital losses, net operating losses, etc.). These losses may offset, partially or in full, the gain on the sale of your property.

  3. You have suspended passive losses from the rental property you wish to exchange. These losses will become non-passive and deductible in full in the year you sell your property. These losses can offset any capital gain on the sale of the property.

  4. You are in a very high tax bracket and need depreciation deductions. Since any gain deferred through a 1031 exchange reduces the cost basis of your replacement property, your depreciation deductions will also be reduced. If you sell your property, pay the capital gains tax and then buy a replacement property, you will not have to reduce the cost basis of the new property.

  5. You do not want to reinvest all of the money from the sale of your property in the replacement property. The money you do not reinvest will be considered boot and you will have to pay taxes on it. It may still make sense to do a 1031 in this case, but you must run the numbers to see how much tax you will pay on the boot and how much the cost basis of your new property will be reduced by the amount of gain deferred.

Disclaimer:  Any tax advice contained in this article is not intended or written to be used, and cannot be used, to avoid penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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