If you ever traded baseball cards with a friend when you were a kid, you're already familiar with the basic principle of a "like-kind exchange". Perhaps your buddy really loved José Canseco and wanted your Canseco rookie card, yet you had a suspicion that his career might end badly. The two of you agreed to swap Canseco for a few of his up-and-coming prospect cards. You calculated the value of your card, and decided which cards of his you wanted in return, then made a swap. It's a safe bet that the IRS didn't get a cut of the action.
A like-kind exchange (also called a section 1031 exchange) allows real estate investors to do a similar thing by deferring capital gains or losses when they buy or sell a property. Essentially, a like-kind exchange allows you to swap investment properties with another investor and keep the taxman out of the deal until much later when the property is eventually sold for cash. Of course, the process isn't quite as easy as swapping a few baseball cards, but this article will show you how it's done.
Why You Should Consider an Exchange
The opportunity to defer tax obligations through a 1031 exchange (named for Section 1031 of the Internal Revenue Code) encourages investors to rebalance real estate portfolios and to put to more profitable uses monies they would otherwise pay in taxes. The ability to rebalance is particularly important in real estate because, unlike individual stocks and bonds, one property can make up a significant portion of a portfolio's value.
Because of the concentrated nature of a real estate investment, it is important for portfolio managers to have the flexibility to rebalance their portfolios and make tactical bets in either different property sectors or investment regions. A 1031 exchange encourages such rebalancing by allowing investors to move in and out of real estate exposures through the exchange of one property for another without the burden of immediately incurring capital gains taxes. By continually using 1031 exchanges when acquiring and disposing of property, investors can defer the capital gains tax until it is time to liquidate some or all of the portfolio, there is a favorable change in the tax law, or they have accrued enough capital losses to offset the capital gain obligation. (For more on making Section 1031 work for you, check out Smart Real Estate Transactions.)
In order to qualify for this tax treatment, investors must adhere to certain requirements and limitations regarding the types of properties they can exchange, the location of the properties and the timing of certain key events. The next section will provide a detailed description of the various requirements, but it's important to first note that a primary residence does not qualify, so unfortunately you won't be able to swap your suburban condo for a beach house in Malibu. (For more on selling a personal residence, read Will Your Home Sale Leave You With Tax Shock? and Is it true you can sell your house and not pay any capital gains tax?)
Coordinating the necessary elements can be a rather daunting task. To help facilitate the necessary trades and documentation, investors are required to use a third-party clearing house called a "qualified intermediary (QI)", which handles all the funds related to the purchase, sale and exchange of properties. Since funds do not flow directly through the taxpayer's accounts, and the taxpayer never has control of any of the cash produced by the transaction, the investor has effectively rolled the capital gains into the exchanged properties and may defer the capital gains tax until the sale of real property assets for cash.
The setup and execution of a 1031 exchange and the corresponding tax treatment of the transaction can be very complex. The next section will give a brief and simplified description of the requirements and steps necessary to execute a 1031 exchange.
The exchange only works for investment real estate or business properties. An investment property is one that is purchased in order to lease and derive income. Business property is one owned and used by a business and is held on the balance sheet as an asset. All real properties in the U.S., whether improved or unimproved, are generally of like-kind. Real property outside the United States is considered "not like-kind" property. Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or personal property of any kind. (For an overview of the different types of property, check out our tutorial Exploring Real Estate Investments and Investing In Real Estate.)
Non-Qualifying Assets and the Boot
If the transaction involves non-qualifying assets (not like-kind) property or cash, then the investor must recognize the gain on the sale and pay taxes accordingly. Assuming that the value of one of the exchanged properties is greater than the value of the other, the non-qualifying assets used to even out the value between the exchanges is called "boot" and is still subject to normal capital gains taxes.
While transactions need not be simultaneous, there are restrictions on certain transaction timing elements. For example, in order to qualify a transaction as a 1031 exchange, an investor must identify the property to be exchanged before closing, and identify the replacement property within 45 days of closing the sale of the first asset. In addition, the transaction to acquire the replacement property must be executed within 180 days of executing the sale of the first deal. For most investors, one of the most difficult tasks is identifying replacement assets within 45 days of selling the relinquished asset. Yet, it is important that they do so because these timing restrictions are very stringent and the IRS does not grant extensions.
Because of the complexity of these arrangements and the requirements and restrictions surrounding the exchange, the investors sponsoring the exchange must use a qualified intermediary to facilitate the deal. The qualified intermediary, defined as a corporation that is in the full-time business of facilitating 1031 exchanges, does not provide legal or tax advice. It cannot be a business party, such as a CPA firm, attorney, or real estate agent that has had any relationship with the taxable party within 24 months prior to the first property transaction. Preferably, the QI should be a third-party business that has not previously provided any of these services to any transaction participants.
The QI performs various facilitation services and acts as a bridge between the parties involved to help structure and execute the exchange. Its duties include:
- Preparing all the required documentation and acting as a clearing house to assure that all appropriate parties receive documentation.
- Ensuring that funds are held in a secured and insured bank account, and that any disbursements are made to escrow accounts when the transactions are completed.
- Submitting a full accounting of the transactions for taxpayer records, and providing a Form 1099 to the taxpayers and to the IRS documenting any required taxes and any capital gains taxes paid.
The IRS's strict rules regarding certain requirements underscores the value of the qualified intermediary and the importance of choosing an appropriate one. One of the QI's major services is to keep transaction participants on track and to ensure that they meet the requirements necessary for taxpayers to qualify for preferential tax treatment of their real estate profits, so it is important that investors research and select their transaction's intermediary carefully. (For related reading, check out The Benefits Of Using A Real Estate Attorney.)
The next section will cover multi-property exchanges and the basic time line investors must abide by.
Multiple Property Exchanges
In a like-kind exchange, an investor is not required to make a one-for-one exchange of properties. Multiple properties can be used on either side of the exchange as long as the following rules are met. These rules are commonly called the "three property", "95%" and "200%" rules.
- The three-property rule - Any three properties may qualify regardless of market value.
- The 95% rule - Any number of properties may qualify as long as the fair market value (FMV) of the properties received by the end of the exchange period is no more than 95% of the cumulative FMV of all the potential replacement properties identified.
- The 200% rule - Any number of properties can be swapped as long as the cumulative FMV of the replacement properties is no greater than 200% of the combined FMV of all of the exchanged properties at the initial transfer date.
Although the IRS is quite flexible in the number of assets it will allow to exchange in order to aid in the deferral of capital gains tax, it is very stringent about the timing for identifying these properties and conducting the exchange.
Transaction Plan and Timeline
Although the transaction plan and timeline for a 1031 exchange can become extremely complex, certain items follow a basic format and are similar for most transactions.
- Initially, an investor wishing to enter into a like-kind exchange will identify the property or properties to be sold - the "relinquished property" - and then, with the help of the intermediary, sell it to a third party. The intermediary receives the funds as seller and secures all funds in escrow.
- With the funds in escrow, the investor has 45 days to select one or multiple "replacement properties" for the exchange, which must be purchased from a third-party seller within 180 days of the first transaction The intermediary acts as buyer, secures funds in escrow, and then forwards the appropriate funds to the seller or sellers. (For help finding a replacement, check out Top 10 Features Of A Profitable Rental Property and Find Fortune In Commercial Real Estate.)
- Next, the QI prepares all of the accounting documentation for the taxpayer that shows that funds have gone through a QI clearing house and that the accounts of the taxpayer/investor have received no funds. The QI also prepares a Form 1099 denoting any capital gains incurred from the creation of non-qualifying "boot" and any taxes paid as part of the transaction and forwards the form to the IRS.
- Eventually the taxpayer will file IRS Form 8824 with the IRS, plus whatever similar document are required by the state in which the properties are located or the taxpayer resides. In addition to facilitating the exchange, the qualified intermediary will also produce all of the exchange documents required by the transactions, such as the property deeds and real estate contracts.
Because the QI has controlled the funds from both the sale and purchase of the exchanged properties, and because the investor has received property in lieu of cash for the sale of the relinquished asset, capital gains are deferred. With the exception of any "boot", capital gains can be deferred continuously through like-kind exchanges until eventually assets are sold for cash. At that point, the accumulated capital gains will be taxed using the prevailing taxation methods.
A like-kind exchange might not be as easy as the baseball card trades of your youth, but it does let you trade your investment properties and keep the taxman out of the deal. By continually entering into these like-kind exchanges, investors can execute real property transfers to increase or decrease exposures to certain property sectors, and at the same time, defer capital gains until the properties are eventually sold for cash. Once you understand the rules of the game, this is a great way to efficiently rebalance your real estate portfolio.