1031 Exchange | Defer Capital Gains Tax | EquityRoots

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What is a 1031 Exchange?

The term '1031 Exchange' comes from Section 1031 of the Internal Revenue Code. It states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment." Simply put, 1031 Exchange is a powerful tax deferral strategy! It offers a property owner the opportunity to defer all federal and state capital gain tax liability, money that would otherwise be paid in taxes, and reinvest that into more valuable property or assets.

What qualifies?

All real estate qualifies for 1031 provided that it is held for investment or business use. Examples of like kind property include but are not limited to:
Some examples of properties commonly sold/purchased for a 1031 exchange include (but are not limited to):

  • Single family rentals
  • Industrial properties
  • Warehouse properties
  • Multi-family properties including high-rise or apartment complexes
  • Hotel / Office / Retail properties
  • Land used for speculation/Development
  • Storage Facilities
  • Medical office/Retail

THE FOLLOWING ASSETS DO NOT QUALIFY:

  • Primary Homes
  • Second Homes
  • Property acquired for immediate resale (ie. Fix and flip)
  • Stocks

What is this like‐kind requirement you speak of?

While a large percentage of the exchanges involve the purchase of commercial property as the replacement property, it is important to expand on the definition of like-kind. All real estate is like kind as long as it is held for investment or business use. For those individuals who no longer wish to be gas station owners, landlords of residential property, or small business owners, they have the option of selling that property in an exchange and reinvesting into a more passive income-producing vehicle such as:

  • Equityroots' Hotel Invesments
  • Delaware Statutory Trusts "DSTs" Investment Property Interests
  • Tenant-In-Common "TIC" Investment Property Interests
  • Triple Net Lease (Net Lease or NNN) Investment Properties
  • Vacant/Undeveloped Land

How does it work?

The IRS has set out a number of requirements that must be met in order to qualify for tax deferral under Section 1031. Both the relinquished property and the replacement property must be qualified property of like-kind, time requirements must be strictly followed, and an actual exchange must take place with the use of a Qualified Intermediary (QI).




Qualified Property of Like-Kind

To classify as qualified, property must be held for either investment or for productive use in a trade or business and exchanged for property of like-kind. This does not necessarily mean the same, exact type of property. Instead, it relates to the nature, character or class of properties. For income tax purposes, real estate is divided into four classifications which is made as of the date the transaction is made: (1) Held for business use, (2) Held for investment, (3) Held for personal use, (4) Held primarily for sale. The first and second classifications qualify for 1031 treatment and the third and fourth do not.

Time Requirements

The IRS imposes two time limitation periods on deferred exchanges and both must be met in order to qualify under Section 1031. An investor must close on the purchase of replacement property or identify potential replacement property within 45 days from closing on the sale of a relinquished property. More than one potential property may be identified for replacement however they must meet either the 3-Property Rule, 200% Rule, or 95% Rule. Exchangers then must close on replacement property 180 days after closing on the relinquished property or the due date for filing their tax return, whatever is earliest.




The Process Defined


1031 Exchange Process. Owner of a relinquished property receives a replacement property as outcome of process.

Real estate used in a trade or business qualifies for 1031 treatment when exchanged for other business or investment real estate. There are two types of real estate used in a trade or business (1) Owner occupied and property is used in the owner's trade or business, (2) Rental income property and act of renting the property qualifies it as a property used in trade or business.



1031 Exchange Timeline. 1031 Exchange process takes 180 days to close on one replacement property.

To avoid 100% capital gain tax liability, your replacement property must be of equal or greater value to the relinquished property. It can take the form of another whole replacement property or a fractionalized property such as a tenant in common form of ownership or an interest in a Delaware Statutory Trust with Equityroots. Any funds not reinvested will be considered 'boot' and taxable. The general rule of thumb is to reinvest 100% of your equity and to replace your debt to avoid tax liability from the sale of your business property.






Don't touch anything: You need a Qualified Intermediary (QI)


As the name implies, to have a valid exchange, the property must be exchanged for other property and purchased through a specific process. This requires knowledge of the different ways a 1031 Exchange can be structured and the advantages, disadvantages, and finer points of each variation. Variations may take the form of a simultaneous swap, deferred exchange, reverse exchange, improvement exchange, or a combination. An important aspect of each variation is that the taxpayer must avoid actual and constructive receipt of proceeds during the exchange process.

Equityroots + Midland IRA = Get it done right.




You can invest in premium branded hotels (tax deferred). As previously mentioned, your replacement property may take the form of another whole property or a fractionalized property such as a tenant-in-common form of ownership or an interest in a Delaware Statutory Trust. This can be especially appealing for investors who desire full tax deferral and want to invest their proceeds into multiple new businesses at once.

Dependent upon the specifics of each project, you may have the opportunity to invest and obtain an interest in a Delaware Statutory Trust which the IRS has ruled that for tax purposes, it is to be treated as a direct interest in real estate under Section 1031.

As to qualify for tax deferral, an Exchanger cannot have access or control over the funds or other property while the exchange in is process. Unless an Exchanger is merely swapping properties in a simultaneous exchange, the IRS has provided that a Qualified Intermediary must be used as a go-between for the sale proceeds in order to avoid this problem.




Frequently Asked Questions


What is the Same Taxpayer Requirement for 1031 Exchanges?

Ans: If you perform 1031 exchanges, you must understand the same taxpayer rule. This rule mandates that the taxpayer who owns the relinquished property must be the same taxpayer who takes ownership of the replacement property.

Why the Same Taxpayer Requirement?

Ans: If the taxpayer changes tax identities, then there would be no continuity of tax. Bear in mind, however, that tax identity is not necessarily the specific name on the property.

Can a Taxpayer Change the Ownership but Preserve the Tax Identity?

Ans: Remember that we are talking about the tax identity, not necessarily the specific name on the title of the property. Below are some examples of the many ways in which a taxpayer can hold title that would preserve the tax identity:

  • In the taxpayer's own name
  • Under a single member limited liability company (LLC) treated as a disregarded entity
  • As the trustee of a Revocable Living Trust
  • As a Tenant in Common (TIC)
  • Under a Delaware Statutory Trust (DST)
  • In a land trust in certain states

How does the Same Taxpayer rule affect the spouses?

Ans: There are times when only one spouse is on the title to the relinquished property and the taxpayer wants to add the spouse to the title of the replacement property. This is not encouraged since the other spouse was not the same taxpayer who sold the relinquished property. Tax advisors and CPAs usually suggest waiting until the exchange is complete and a reasonable amount of time has passed to add a spouse to the title. Waiting several years should be sufficient.

What happens during a death of a Taxpayer in a 1031 Exchange?

Ans: Unfortunately, sometimes a taxpayer passes away after the sale of the relinquished property, but before the purchase of replacement property. If the continuation of the exchange in these instances was not allowed, the estate is taxed on the gain from the sale. However, despite the fact that a deceased individual and his or her estate are not considered the same taxpayer, IRS regulations do allow the estate to continue the exchange transaction and receive tax deferral treatment.




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