Welcome to the AMT 1031 Learning Center

Benefits of a 1031 Exchange

There are several benefits to doing a 1031 Exchange.  First and foremost, and the benefit that gets all of the attention, is that the taxation on the capital gains is deferred.  That certainly is great news and a reason all by itself to use a 1031 exchange as part of your investment strategy.  But, there are additional benefits as well.  Not only will a 1031 exchange defer the federal taxes on a capital gain, but it will also defer any applicable state capital gains taxes, any depreciation recapture and possible Net Investment Income Tax.  

As if all of those reasons aren’t enough, there are other, more intangible, benefits of utilizing a 1031 exchange.  The deferral of taxes effectively gives the exchanger an interest-free loan from the government.  By utilizing this “loan” to acquire replacement property, the exchanger enjoys more “buying power”.  In theory, this would allow you to buy a bigger replacement property than you otherwise would have.  And you get the benefit of the long-term appreciation on the larger investment property.  

1031 exchanges, in general, allow you the flexibility of diversifying your portfolio by obtaining a replacement property of a different kind than you currently own, or even obtain multiple properties as replacements.  

Lastly, you can use Section 1031 as an estate planning tool.  If you pass away as the owner of the 1031 property, your heirs will inherit the step up in basis.  That qualifies as the ultimate tax deferral, as all previously deferred gains would simply go away upon your passing.

Basic Requirements

The provisions of Section 1031 require that the same taxpayer own both the property to be relinquished as well as the replacement property. Additionally, that taxpayer cannot own both properties at the same time and you cannot take actual or constructive possession of the sale proceeds or else the transfer will fail.   That’s where the use of a Qualified Intermediary (QI) comes in. The QI will retain possession of the sale proceeds and will use the proceeds in accordance with its signed agreement with you to acquire title to the replacement property.  All properties involved must be like-kind, which basically means that it must be real estate, located in the United States, that is used for business or investment purposes. Those are the basic requirements in order to qualify the exchange for tax deferred status, but there are specific rules about identifying the replacement property and strict timelines by which certain steps must be completed. Please reach out to the team of experts at AMT 1031 for additional information or to ask any questions that you may have.

Time Periods

There are two critical deadlines that must be met in order to qualify as a 1031 Exchange.  The first is the 45 Day Rule, which gives the exchanger 45 days (from the date the relinquished property is sold) to identify the potential replacement property or properties.

The second important time period requires that the replacement property be acquired within 180 days from the date the relinquished property was sold.  It’s important to note that both of the referenced time periods commence at the same time (the date the relinquished property is sold) and they run concurrently.  Many people mistakenly assume that the 180 day time period starts running after the replacement property has been identified.  This is incorrect and will result in the exchange failing to meet the 1031 criteria.  Please consider AMT 1031 as a trusted partner in this process as we will track all deadlines and we will give reminders so nothing gets missed.

Rules About Identifying Properties

Once the relinquished property is sold, you have 45 days to identify the potential replacement property or properties.  Note that this is calendar days, not business days.  The replacement property must be identified within the time period, signed by you as the exchanger and submitted to the QI.  There are three rules dealing with the proper identification of replacement property.  The most commonly used is the Three-Property Rule.  This allows the exchanger to identify up to three potential replacement properties.  The individual or aggregate values are irrelevant, so long as you purchase real estate that was properly identified and you meet all other criteria for a 1031 exchange (eg. time periods and valuation requirements).

If necessary, an exchanger can utilize the second rule of identification – known as the 200% Rule.  This allows the exchanger to identify more than three properties so long as the total combined value of the identified properties does not exceed 200% of the fair market value of the property being relinquished.  It’s important to note that these two rules are separate and distinct.  For example, if the relinquished property is being sold for $200,000.00, you can identify any three properties you like.  They could have a combined value of $50,000,000.00 if that suits your needs.  If, and only if, you identify more than three properties, the 200% rule will take over.  Then you could identify four (or more) properties, so long as their combined value doesn’t exceed $400,000.00 (which is 200% of the value of the property being relinquished).

If both of the above-mentioned rules of identification are violated, there may be a saving grace.  It’s not very commonly used, but it has saved more than one 1031 exchange that would have otherwise failed.  If you identify more than three properties and the combined value of the identified properties is more than 200% of the value of the relinquished property, the 1031 exchange can still be successful if 95% of the combined value of the identified properties is actually acquired.  To continue with our last example, the relinquished property is being sold for $200,000.00.  The exchanger identified five properties worth a combined $1,000,000.00.  The exchange still satisfies the identification criteria if the exchanger actually acquires identified properties worth a combined $950,000.00 (which is 95% of the $1,000,000.00 in combined value).  It is a rare scenario, but having a partner who knows all of the ins and out of 1031 exchanges is key to a successful transaction.

Like all of the requirements for a 1031 exchange, the requirements around identifying properties are strict and the failure to comply will result in the exchange failing and the capital gains taxes will be due.

Types of Exchanges

 

Forward Exchange

A 1031 forward (or delayed) exchange is a swap of one real estate investment for another (of equal or greater value) which, if done correctly, will defer all (or substantially all) capital gains taxes that would otherwise have been due.  It is imperative that the exchange meets all of the criteria laid out in Internal Revenue Code Section 1031 (hence the name “1031 Exchange”).  If all of the criteria are not met, then the exchange fails and the capital gains taxes will be due from the transferor.
 

Reverse Exchange

A Reverse Exchange is when the replacement property must be acquired prior to the sale of the property being relinquished.  This scenario can happen for many different reasons, such as the potential loss of the purchase opportunity if the closing isn’t expedited.  There are several types of reverse exchanges with the most common being a parking arrangement.   In this situation, the third-party exchange company takes title to the new property as the Exchange Accommodation Titleholder (EAT).  This is accomplished with money loaned (or borrowed) by the exchanger and given to the EAT.  Title to this new/replacement property is “parked” in the name of the EAT, until such time as the exchanger completes the sale of their current property.  Note that the timeline of 180 days still applies to this type of transaction so the sale must be completed within 180 days of the acquisition of the replacement property by the EAT.  When the sale is completed, a normal/forward exchange is completed whereby the exchanger sells their current property and acquires title to the replacement property from the EAT.  Essentially, there are two separate, but required, components to complete a Reverse Exchange – the parking arrangement followed by a traditional forward exchange.  
 

Improvement Exchange

An improvement exchange is used when an exchanger wants to use the sale proceeds to make improvements to the replacement property.  Sometimes that is for convenience or to make better use of the replacement property.  But, sometimes it’s necessary in order to use all of the sale proceeds, thereby fully-deferring the capital gains taxes.  Regardless of the reason, an improvement exchange is more complex and great care must be taken to make sure that the exchange will comply with all of the requirements of Section 1031.  Having an expert on your team, like AMT 1031, is vital to the success of the exchange.  You cannot own both the relinquished property and the replacement property at the same time and you cannot use sale proceeds to complete construction on property that you own (the replacement property).  Therefore, you need to create an Exchange Accommodation Titleholder (“EAT”) to initiate the acquisition on your behalf.  The EAT will use the sale proceeds to acquire title to the replacement property and will oversee the improvements.  Once the improvements are done (so long as it’s within the 180 day time limit) the EAT will then sell the replacement property to you at the increased valuation, thereby completing the 1031 exchange.  While the rules are strict, there are creative ways to take advantage of the tax deferred exchange if you have the right partner on board to guide you through all of the nuances.