A financial advisor’s foremost responsibility is to take care of clients and their assets. Clients trust advisors to guide them toward the investment opportunities that best fit their needs and goals. 1031 exchanges (named for Section 1031 of the Internal Revenue Code) can represent a great option for investors — including retirees — who want to defer taxes on the sale of an investment property and use the proceeds to invest in other real estate. However, these exchanges can be difficult to understand and some investors may not be aware of the opportunities they present.
1031 Exchange Process
1031 exchanges require a very specific process, which must be thoroughly explained to investors so they have the greatest chance of success. For instance, many people don’t realize that they can’t put the proceeds from a sale into a personal bank account if they want to use it toward a 1031 exchange. In such a scenario, the investor would be liable for the taxes.
1031 exchanges can only be executed if the proceeds go into an account held by a qualified intermediary, which could be either an institution or individual. It’s important to be careful about selecting the qualified intermediary, since investors are giving that institution or individual limited power of attorney over their money.
Once the money goes into an account with a qualified intermediary, the investor has a 45-day identification period to find properties they would like to purchase. This is a strict time frame — there are no extensions, and holidays and weekends count. The identification form needs to be turned in by 11:59 p.m. on day 45 to successfully conclude this period. The investor then has 135 days to close on the property or properties listed on the identification form for a total of 180 days from sale to close.
Three Identification Rules
There are three primary rules that investors can follow during their identification period to find properties they may want to purchase: 1) the Three-Property Rule, 2) the 200% Rule and 3) the 95% Rule.
The Three-Property Rule limits an investor to no more than three desired properties, with an unlimited combined value. So if an investor sells a property for $5 million, they can vastly exceed that dollar figure when identifying properties, but the number of properties is capped at three. This rule benefits investors because they must only provide addresses on their identification form and don’t have to include any share of market value or percentage of ownerships. The downside is that an investor gets only three choices, because at least one of the properties needs to go through for a successful exchange to occur.
The 200% Rule is less well known, although it is the more commonly used option for Delaware Statutory Trusts (“DSTs”). This rule doesn’t limit potential addresses but it does cap overall value. Using the $5 million sale example, the investor would be limited to a combined value of $10 million for any identified properties. Another aspect to be aware of with this rule is that the investor needs to ultimately close on 75% or more of the identified value. So if $10 million is identified, at least $7.5 million in properties must be bought or the exchange could be disallowed by the IRS.
The 95% Rule is used the least, but offers investors unlimited addresses and value. The downside to this approach is that investors must close on at least 95% of the properties they list on their identification form, providing a slim chance for a successful exchange. If an investor wants to buy DSTs, which can contain multiple properties, the 95% rule may be a good choice since the DST would allow them to close on 100% of the identified properties.
Commonly Asked Questions
1031 exchanges can be difficult to grasp due to the strict rules that must be followed in order to complete them and defer taxes. Understandably, investors usually have many questions about the process. For example, they might get confused about the like-kind rule, which states that only like-kind investments can be exchanged.
In this context, they could worry about selling a certain type of property and not being able to find a similar property they want to exchange it for. But in 1031 exchanges, like-kind just means similar in nature, character or class. The IRS outlines like-kind exchanges: When you exchange real property used for business or held as an investmentsolely for other business or investment property that is the same type or “like-kind.” For instance, land can be exchanged for an apartment building, which could then be exchanged for a house. But an investor can’t exchange real estate for other assets such as precious metals or fine art.
Another aspect investors don’t typically know about is that there are ways to defer taxes on personal property. Prior to tax reform in 2017, personal property could actually be used in an exchange. That’s no longer allowed, but investors can perform a cost-segregation analysis on property they’ve acquired, purchased or built, in order to reduce their taxable income by accelerating the personal property’s depreciation that is within the real property.
Cost segregation will be reduced by 20% each year. For example, this year it’s 100% accelerated depreciation, next year it will be 80%, then 60%-40%-20%; then it will transition to a five-, seven- or 12-year schedule. This could be a compelling strategy for investors seeking to shelter cash flow from taxes on personal property.
One concern on the horizon is an effort by the Biden administration to cap the tax deferral offered by 1031 exchanges. A proposal in President Biden’s 2023 budget would limit the deferral of gains up to an aggregate amount of $500,000 for each taxpayer ($1 million for married individuals filing a joint return) each year for real property exchanges that are like-kind. Any gains from like-kind exchanges over $500,000 (or $1 million for married individuals filing a joint return) a year would be taxed in the year the taxpayer transfers the real property subject to the exchange.
Nevertheless, 1031 exchanges can present real estate investors with unique opportunities that entail significant tax benefits. For many advisors, it would make sense to become better educated about the process and regulations, so they can have informed discussions with interested clients and help determine when a 1031 exchange might be an appealing option.
Edward Fernandez is president and CEO of 1031 Crowdfunding, a real estate investing platform for 1031 exchanges and alternative investment vehicles focused on tax deferral.