Key Questions: What Is a 1031 Exchange?
The Key Wealth Institute is a team of highly experienced professionals from across wealth management who are dedicated to delivering commentary and financial advice. From strategies to manage your wealth to the latest political and industry news, the Key Wealth Institute provides proactive insights to help grow your wealth.
A 1031 exchange, also known as a like-kind exchange, occurs when a taxpaying individual investor or entity sells an investment property and reinvests the proceeds into a “like-kind” replacement property. Like-kind exchanges were created as part of the Revenue Act of 1921, and the 1954 Amendment to the Federal Tax Code created Section 1031, where you can find the complete rules to follow for a 1031 exchange. Federal tax law under the Internal Revenue Code (IRC) Section 1031 states: “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.” Generally, a 1031 exchange permits a taxpayer to defer all capital gains and depreciation recapture taxes on proceeds from the sale. The reasoning for the deferral is because taxpayers are simply exchanging one investment for another, and capital gains are not eliminated but exchanged. Partial 1031 exchanges are permitted, although any proceeds kept out of the exchange are taxable.
To complete a successful 1031 exchange, once a buyer is selected, the purchase contract should indicate an intent to sell the property as part of a 1031 tax-deferred exchange. The taxpayer cannot take possession of the proceeds from the original investment property or the exchange will be disqualified. Instead, the services of an unrelated third-party professional must be assigned to serve as a Qualified Intermediary (QI) or 1031 Accommodator to hold proceeds and facilitate the exchange. A taxpayer has 45 calendar days following the close of escrow to identify a replacement property and a total of 180 calendar days following the close of sale of a relinquished property to acquire replacement property.
Which replacement property types qualify and which do not? Property types that do not qualify under a 1031 exchange include but are not limited to:
- Personal primary residence or second home.
- Stocks, bonds, and notes.
- Certificates of trust or beneficial interests.
- Partial interests in partnerships.
Any property held for investment or business purpose qualifies for a 1031 tax-deferred exchange, e.g., land such as a farm, residential rental property, or an investment offering structured as a Delaware Statutory Trust (DST) interest.
A taxpayer can complete a 1031 exchange by investing in a DST, a diversified portfolio of passive income-producing real estate. A DST is a fractional ownership structure where multiple investors can share ownership in a single property or a portfolio of properties. A taxpayer may choose to explore this option to move from an actively managed asset to a passive asset or to diversify and minimize risk in a real estate portfolio.
Taxpayers can continue to defer capital gains taxes using 1031 exchange transactions until assets are passed on to their heirs. DST shares can be evenly divided and passed on to multiple heirs. When a real estate property is passed to heirs, whether held directly or through a DST, the basis by which the capital gains are determined steps up to the current market value at the time of inheritance. After heirs inherit the investment property, they may sell it for its current value without realizing any taxable capital gains. A taxpayer can also exit their DST investment and purchase a single asset of their own selection.
Although the like-kind or 1031 exchange process has survived 100 years of proposed modifications by several administrations, there is a possibility of limitation or elimination. The most recent reform was the Tax Cut and Jobs Act passed in December 2017 under the Trump administration that excluded personal and intangible property in the 1031 tax-deferral calculation. Under the current Biden administration, one proposed change seeks to limit 1031 exchanges to $500,000 of capital gains, or $1 million if married. The justification for the reform is to potentially be a “pay-for” for the infrastructure plan.
The administration has proposed an effective date for the limited 1031 deferral provision to be completed in tax years after December 31, 2021. If the proposed tax plan passes, there may be implications for real estate investing and the economy. In addition, investing in a 1031 exchange also subjects the investor to other risks. If the rules for like-kind exchanges are not specifically adhered to per the Internal Revenue Service, taxpayers may be held liable for taxes, penalties, and interest on the transactions.
For long-term investors seeking tax-deferral benefits of the 1031 exchange or a stable and passive income backed by institutional-quality real estate, a DST may be a replacement property for the exchange of their property and provide better estate planning. Please consult a tax advisor or CPA regarding your situation and the specifics of reporting a 1031 exchange.
For more information, please contact your Key Private Bank Advisor.