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Four Concepts to
Understanding a 1031 Exchange
An IRS Section 1031 tax deferred exchange is both a complex technique and a simple set of
concepts.
The complexities of a 1031 exchange come from having to follow an intricate set of rules
found in the IRS tax code and the regulations that further explain those rules. The
simplicity of an exchange can be explained by reviewing a set of four basic concepts.
The premise of a 1031 exchange is based on “relinquishing” a property and
acquiring a replacement property following a set of rules and guidelines provided by the
IRS. Done correctly and following all the rules, a taxpayer may save payment of taxes.
The underpinnings of an exchange are based on the continuity of ownership interest in real
property. That is, if a taxpayer sells or “relinquishes” a property and receives
replacement property, following all required steps, the IRS will look at that sequence of
transactions as if the taxpayer never really got rid of a property. It is as if he or she
continued to own real estate the whole time. Here are details:
1. Tax Strategy – The major motivation of an investor in considering a 1031 exchange
is to keep from paying capital gains taxes on the sale of an investment property. The
current capital gains tax rate is 15% for long term gain (profit). While this rate seems
low, there is more to the equation. For improved property (rental houses, commercial
property, etc.) accumulated depreciation deductions must be recaptured and taxes will be
due at a rate of 25%. Finally, there is a state level tax. In Georgia, the taxpayer will
owe 6% on the profit (appreciation) as well as 6% on the depreciation recapture.
For example: Assume an investor purchased a rental house for $100,000, and held it for a
number of years with total depreciation deductions of $40,000. If the property were to be
sold for $200,000, the investor could have a tax liability of over $33,000.
2. Replacement property – To keep from paying $33,000 or more, the sale of the first
rental property must be linked through specific documentation to the purchase of
replacement property. In acquiring replacement property, the investor must comply with the
basic premise that this tax code section applies to “property held for investment or
for use in a trade or business”. Typically, the phrase "like kind" is used
when describing replacement properties. Any kind of real estate would be considered like
kind as long as it was held for investment.
3. Time requirements – The IRS provides two very specific time constraints for
completing a 1031 exchange. From the day the relinquished property is sold, the investor
has a total of 180 days to acquire replacement property. The 180-day replacement period is
similar to the now repealed primary residence “2 year rollover rule” which
allowed homeowners to defer gain on the sale of a residence if they bought a replacement
within the prescribed time period.
The second and tougher rule to follow is the Identification Rule that requires investors
to choose one or more replacement properties. These target properties must be listed in
writing on a Target Identification Letter by the 45th day following the close of the first
property. The target ID letter is held by the facilitator known as a “qualified
intermediary” to comply with IRS requirements.
4. Equal or greater value – The last concept for a successful totally tax deferred
exchange is acquiring property with a value equal or greater to the value of the property
being sold. There are two components to this rule. First, all of the equity or cash from
the first property must be “spent” on acquiring the replacement property or
properties. Second, the total value of replacement property must equal or exceed the value
of the relinquished property.
If there was mortgage on the first property, generally the equal or greater requirement
simply means that the taxpayer will get a mortgage on the replacement property in an
amount equal to or greater than the original debt.
In summary, the key concepts in a tax deferred exchange involve the following – (1)
saving federal and possibly state capital gains taxes on the sale of investment property
by (2) acquiring replacement property of a like kind within (3) a time period of 180 days
after properly identifying replacement property within 45 days and (4) spending the equity
forward on property of equal or greater value.
John Mangham, CPA
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