FAQs
Frequently Asked Questions
A 1031 exchange, also known as a like-kind exchange, is a tax strategy that allows property owners to defer taxes on the sale of real estate used for business or investment purposes. The “1031” stands for “Section 1031 of the Internal Revenue Code (IRC).” It says:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
Under Section 1031 of the US tax code, if certain requirements are met, the taxpayer can sell a property and reinvest the proceeds in another property of similar nature (like-kind property) without incurring immediate tax liabilities on the capital gains. This allows individuals to preserve their investment capital and potentially grow their real estate portfolio. It’s important to note that the replacement property must be identified and acquired within specific timelines outlined by the IRS.
The summary below provides general guidance on the various taxes that can apply to the sale of investment real estate. Before entering into a 1031 exchange, we strongly urge Exchangors to consult with their tax advisor to review their true potential tax liability of any transaction.
A capital gain is the amount you sell an asset for minus your Basis in the asset.
How is the Basis calculated? Generally, the amount you paid for the asset plus capital improvements invested in the asset.
As an example, let’s say you purchased a property for $100,000 in 2015. In the years that followed, you put on a new roof (for $10,000) and installed a new HVAC system ($7,500). You sold the property in 2022 for $200,000. Your capital gains calculation is:
Basis calculation:
Purchase Price: $100,000
Roof: $ 10,000
HVAC: $ 7,500
=> Basis: $117,500
Capital gains calculation:
Sale Price: $200,000
Less Basis: -$117,500
=> Capital Gain: $ 82,500
Without a 1031 exchange, you would pay the applicable capital gains rate on the $82,500, which depends on your income in that year. As of 2022, capital gains rates are:
Filing Status & Related Income Limits
Rate | Single | Married Filing Separately | Married Filing Jointly | Head of Household |
0% | Up to $41,675 | Up to $41,675 | Up to $83,350 | Up to $55,800 |
15% | $41,676 to $459,750 | $41,676 to $358,600 | $83,351 to $517,200 | $55,801 to $488,500 |
20% | Above $459,750 | Above $258,600 | Above $571,200 | Above $488,500 |
However, tax liability does not stop there. You must also pay taxes on Depreciation Recapture. Each year you filed income taxes since you acquired the property, you likely claimed depreciation expenses. When you sell the asset, if the sale price is greater than the basis, you must pay tax on the recaptured depreciation – which is the total amount of depreciation you claimed on your income taxes over the years.
Depreciation recapture is taxed at a higher rate than capital gains – 25%.
Finally, you may also be liable for the Net Income Investment Tax (“NIIT”) of 3.8% on the net earnings from the sale of your asset depending upon your income levels. The NIIT applies if your income is greater than the applicable thresholds (as of 2022) set below:
Filing Status | Threshold Amount |
Single | $200,000 |
Married Filing Jointly | $250,000 |
Married Filing Separately | $125,000 |
Head of Household | $200,000 |
Before entering into a 1031 Exchange,
- Capital Gains Rates (2018)
- Long Term (assets held for over 1 year)
- 15% (income between $39,376 – $434,550)
- 20% (income above $434,550)
- Long Term (assets held for over 1 year)
- Short Term (assets held less than 1 year) – ordinary income tax rates
- State taxes (in Missouri – 5.9%)
Upon the eventual sale (and taking the proceeds) of assets in a 1031 exchange, the capital gain is calculated using the final sale price, but your basis begins from the original asset basis (plus additional equity investment at the time of purchase and/or capital improvements, and less depreciation).
Real property which is held for either investment purposes or for productive use in a trade or business is considered “like-kind”. Real estate “held primarily for sale” (i.e., property held by a developer, builder, investor, flipper or rehabber) does not qualify.
By this definition, nearly all types of real property are included and may be exchanged for one another. Examples include:
- Raw land or farmland;
- Residential, commercial or industrial rental property
- Vacation rental property (subject to personal use restrictions)
- Mineral property rights;
- Tenant-in-common interests or Delaware Statutory Trust interests.
Boot is anything that the taxpayer receives in an exchange that is not like-kind to the property traded in the exchange. It can be in the form of cash boot or mortgage boot.
If the Exchangor takes some cash at closing or does not utilize all of the funds in the 1031 exchange account, that portion is considered boot.
If the Exchangor does not replace all of the mortgage debt in the Replacement Property, that portion is also considered boot. (i.e.., if the mortgage payoff on the Relinquished Property was $100,000, and the mortgage on the Replacement Property is $80,000, there was boot of $20,000).
A partial exchange is one in which the Exchangor does not “replace” all of the relinquished property – whether in the form of equity or debt. In a complete exchange, the exchanger must re-invest all of the sale proceeds AND replace all of the mortgage debt from the relinquished property.
If the taxpayer wishes to take some cash at closing (for any reason whatsoever) or simply cannot find a replacement property at a high enough value, the taxpayer will complete a partial exchange.
The portion of the proceeds not reinvested (or mortgage debt not replaced) is called “boot” and is subject to capital gains and depreciation recapture taxes.
The tax liability will be on the lesser of a) the amount of boot received at closing or b) the capital gain. For example, if your capital gain on a sale is $100,000, and you take $50,000 in cash proceeds, you will be taxed on the $50,000 taken at closing. However, if your capital gain is $50,000 and you take $100,000 at closing, you will pay taxes on the entire gain.
Yes. The Qualified Intermediary can provide the earnest money to the title company, but will require that any release of the earnest money is returned to the Qualified Intermediary (which will be documented in the Assignment of Contract). Alternatively, if the Exchangor provides the earnest money from their own funds, it can be refunded from the exchange account at closing.
There is no black-and-white rule as to how long a property must be sold prior to doing a 1031 exchange. The IRS has allowed exchanges to proceed where property has been held for less than one year, but it has often disallowed such exchanges.
As the tax being deferred is the federal capital gains tax, which applies to properties held for at least one year, the general guidance follows that same rule – properties should be owned for at least a year.
If you wish to perform an exchange on a property held for less than one year, we require a letter from your CPA confirming that the transaction qualifies for a 1031 exchange.
The exchange follows the taxpayer. Either the entire LLC must participate in the exchange, or exchange cannot happen. One possible solution is to divest ownership into the individual partners names (or individual’s LLCs) prior to selling, with the general guidance being to divest at least one year prior to the eventual disposition date.
It depends. Vacation homes that are used primarily for personal use do not qualify for a 1031 exchange (whether as a relinquished or a replacement property).
Vacation homes that meet the safe harbor as established by the IRS can qualify for a 1031 exchange. That safe harbor requires that in the two 12-month periods immediately preceding the sale of Relinquished Property, the Exchangor must have A) rented the property for at least fourteen or more days; and B) personally used the property for the greater of a) fourteen days or b) ten percent of the number of days it was rented at fair market value. The same rules apply on the Replacement Property – but on the two 12-month periods following the acquisition.
Absolutely. The other side will have to execute documentation in conjunction with the exchange, so the best practice is to include a statement in special agreements. In addition, when listing the property, we recommend that the broker include a comment in the marketing remarks of the listing that the property will be part of a 1031 exchange.
Here is recommended contract language:
Verbiage on the listing/marketing remarks:
Seller is performing a Section 1031 tax-deferred exchange on this property; the buyer may be requested to execute documents related to the said exchange. The special agreements in any proposed sale contract should contain the following clause:
“Buyer acknowledges Seller intends to perform a Section 1031 tax-deferred exchange and Buyer agrees to reasonably cooperate in executing documents necessary for the 1031 exchange.”
Verbiage on the special agreements on sale contract for relinquished property:
Buyer acknowledges Seller intends to perform a Section 1031 tax-deferred exchange and Buyer agrees to reasonably cooperate in executing documents necessary for Seller’s 1031 exchange.
Verbiage on the special agreements on sale contract for replacement property:
Seller acknowledges Buyer is completing the back-end of a Section 1031 tax-deferred exchange, and Seller agrees to reasonably cooperate in executing documents necessary to complete Buyer’s 1031 exchange.
- You have 45 days to complete the identification.
- The properties you identify are potential replacement properties. Just because you identify a property does not mean you must purchase it.
- You must identify a specific property. You cannot identify something generically, such as “a 2-4 family building in the City of St. Louis, Missouri” or “any unit in ABC Condominium, 123 Main St., Destin, Florida”. It must be “123 Main St., Unit 101, Destin, FL”.
- In the case of a tract of land without a physical address, utilize the parcel identification number from the county assessor, i.e., “Parcel 12345678, St. Clair County, Illinois”
- You can make any changes during the 45 day identification period. After that expires, whatever properties are on the final identification are the ONLY properties you may purchase with the 1031 exchange funds.
First, note that there are no restrictions if the Exchangor closes on the Replacement Property(ies) within the 45 day identification period.
There are three options, or “rules” to consider when identifying properties:
- The “Three Property Rule”: you may identify a maximum of three properties. There are no other restrictions; they may be any value.
- The “200% Rule”: you may identify any number of properties, so long as the aggregate value of the identified properties does not exceed 200% of the value of the relinquished property; the identification must recite the market value* of each property.
As an example, if the relinquished property sold for $200,000, the maximum combined value of the identified properties cannot exceed $400,000. You could identify five $80,000 properties. - The “95% Rule”: you may identify any number of properties, so long as you close on 95% of the value of the identified properties; the identification must recite the market value* of each property.
This rule is commonly used when an assemblage is part of the Exchangor’s plan, or when an Exchangor is acquiring several condominium units with the intent of converting them to apartments. We only recommend that this option be used if the Exchangor is absolutely certain they will be closing on the properties.
*For market value, the amount listed on the identification should be have documentation backup in the Exchangor’s file. The Qualified Intermediary will not determine what market value is, nor will we verify that it is sufficient.
Pursuant to IRS guidelines and the terms of the Exchange Agreement, the following rules set forth when exchange funds can be returned to the Exchangor (once the closing of the Relinquished Property has occurred):
- After the 45 day identification period, if no properties were identified;
- After the purchase of all of the identified properties is complete;
- After the 45 day identification period expires, and there is a material and substantial change to the remaining identified property preventing purchase (subject to many requirements);
- After expiration of the 180 period if there are remaining, unacquired, identified properties.
Put in more simple terms:
- If you don’t identify any properties, you will receive your funds on Day 46;
- If you identify properties – but REVOKE the designation before Day 45, you will receive your funds on Day 46;
- If you close on all of the identified properties and funds remain, you will receive your funds on Day 46 or upon closing of the final property, whichever is later;
- If properties have been identified that you will not purchase AND it is beyond Day 46, you will receive your funds on Day 181.
What is a Related Party? As defined by the Internal Revenue Code a Related Party includes:
- Members of the same family unit (siblings, spouse, ancestors, and lineal descendants);
- Corporation where more than 50% of the value of the stock is owned directly or indirectly by or for one particular individual (who is involved in the exchange);
- This includes two (2) corporations that are in the same controlled group;
- An individual and that individual’s trust; and
- Different iterations of the above concepts.
Yes, but there are additional requirements. Both the Exchangor and the Related Party must hold the properties received in the exchange for a minimum of two years (i.e., the Related Party must own the Relinquished Property for at least two years following closing, and the Exchangor must hold the Replacement Property for at least two years as well).
In the event that either party disposes of either property within the two year period, the exchange will be disallowed and the corresponding tax liability will be recognized by the IRS.
There are some additional exceptions to this rule – always consult with your tax advisor before entering into an exchange transaction involving a Related Party.
Generally, no. The Internal Revenue Service considers the acquisition of a Replacement Property from a Related Party as “tax basis swapping,” and requires the taxpayers to recognize depreciation recapture and capital gains tax liabilities. However, if both parties to the transaction are performing 1031 exchanges, it is possible to use property from the Related Party – and as noted above, this should happen under the strict guidance of your tax advisor.
For more information on this topic, the Internal Revenue Service issued Revenue Ruling 2002-83 on November 25, 2002, which set forth its position on related party transactions.
You are selling a property you hold in your individual name, and want to buy a property in an LLC. This is perfectly acceptable so long as the new LLC is a single-member LLC (a/k/a disregarded entity), i.e., an entity that does not file a separate tax return. The exchange follows the taxpayer; so long as the taxpayer identification number (social security number or EIN) is the same on the relinquished property as it is on the replacement property, the actual name is not relevant.
Allowable closing expenses for 1031 exchange purposes include:
- Real Estate Commissions & Fees
- Title & Escrow Fees
- Attorney’s Fees
- Recording & Filing Fees
- Document Preparation Fees
- Transfer Taxes
- Mortgage/origination Fees
Expenses which are excluded (and result in a taxable event if paid with closing proceeds) include:
- Pro-rated Rents
- Security Deposits
- Property Taxes (whether prorated or not)
- Association Dues (whether prorated or not)
- Utilities (whether prorated or not)
- Insurance Premiums
- Tax/Insurance Escrows
- Repairs & Maintenance
To maximize the tax deferral and reduce the tax burden, we recommend paying “excluded expenses” outside of closing – which often involves the seller bringing cash to closing to cover these matters.
As with all other matters involving a 1031 exchange, the closing statement should be reviewed with the Exchangor’s tax advisor and/or attorney prior to closing.
When selling a property in the United States, the Exchangor must purchase the replacement property in the United States – which includes all 50 states plus the U.S. Virgin Islands, the Northern Mariana Islands or Guam. Foreign property is not considered “like kind” to domestic property.
It is possible to do a 1031 exchange when the taxpayer is selling international property and the replacement property is also international, and the same rules apply with respect to timeline, like-kind property, etc. However, Title Exchange Services does not provide international services.
For Title Exchange Services, a DST is no different than any other type of property. We do not do anything to set up the investor with a sponsor.
A DST is a separate legal entity created as a trust that allows multiple investors to pool their money to invest in real estate properties. The DST can be a great option for Exchangors struggling to find a suitable replacement property or for an investor looking to divest from actively-managed investments into a passive portfolio. Title Exchange Services is well versed in the DST world, both with using a DST for replacement property, or when a DST is being sold and accommodating an exchange from a DST into another DST. To learn more about 1031 exchanges with DST, check out this blog from our sister company, True Title.
Yes, we absolutely recommend the disclosure on the contract using the following suggested language:
Verbiage on the special agreements on sale contract for relinquished property:
Buyer acknowledges Seller intends to perform a Section 1031 tax-deferred exchange and Buyer agrees to reasonably cooperate in executing documents necessary for Seller’s 1031 exchange.
Verbiage on the special agreements on sale contract for replacement property:
Seller acknowledges Buyer is completing the back-end of a Section 1031 tax-deferred exchange, and Seller agrees to reasonably cooperate in executing documents necessary to complete Buyer’s 1031 exchange.
The only requirement to be eligible for an exchange is that a person or entity must be a US taxpayer. All taxpayers qualify, including individuals, partnerships, limited liability companies, S corporations, C corporations, and trusts. There are no citizenship requirements, meaning anyone paying taxes to the US can participate, including DACA recipients and foreign companies. A taxpayer can preserve tax identity without holding title under their name by holding title under a “tax disregarded entity,” which is not considered separate from its owner for tax purposes. Taxpayers may also be eligible by holding title under a Delaware Statutory Trust .
Standard Exchange Rules and Process