1031 Exchanges As Powerful Real Estate Investment Tools
A Practical Guide to Leverage Their Benefits and Avoid Potential Pitfalls
1031 Exchanges – A Primer
1031 exchanges are a powerful tool. For the savvy real estate investor, a 1031 exchange can reduce risk and increase diversification. In short, the investor can redeploy assets into other types/classes of real estate or in different geographic locations without triggering high levels of income taxation.
1031 exchanges allow owners to sell business related real estate and invest the proceeds in another “like-kind” property without triggering capital gains tax, or depreciation recapture at a 25% tax rate. Like-kind refers to an exchange of properties of the same “nature, character, or class” as defined by the IRS. Real estate is generally of “like kind,” although real estate in the United States is not like-kind to offshore real estate and vice versa. In addition to deferring capital gains taxes, 1031 exchanges help defer depreciation recapture taxes until an ultimate sale.
Previously, 1031 Exchanges were applicable to personal and intangible property, in addition to real estate, but following the Tax Cuts and Jobs Act of 2017, they can now only be used for real estate.
1031 Exchanges are subject to an important IRS timing limitation – investors have up to 180 days from the sale of the original property to acquire a replacement property or properties. This timing is not guidance- it is absolute. Failure to meet the timing requirements will invalidate the 1031 exchange.
Here, we review the details of 1031 exchanges, their many powerful benefits along with where to be extra careful.
Practical Applications of 1031 Exchanges
1031 Exchanges are practical in a variety of situations and an increasing number of real estate investors are beginning to employ the vehicle.
Some investors use 1031 exchanges as a portfolio diversification opportunity, for both type of property as well as geographic location. Using Manhattan real estate as an example, the current market context is complicated for apartment owners. Many investors are looking to exit out of multifamily apartment complexes due to changes in rules and regulations in local jurisdictions. Depending on an investor’s thesis, 1031 exchanges allow for migration of ownership into assets that may perform more in line with an investor’s expectations. 1031 exchanges permit investors to move into different classes of properties in the same – or different – geographic market. For example, an investor can exchange a multifamily property for a single tenant property without incurring tax burdens.
There are a number of different types of 1031 exchange operations:
- Reverse exchange:
- In a reverse exchange, the “replacement property” is acquired before the sale of the “relinquished property.” With financing, a Qualified Intermediary (QI) purchases the replacement property via an LLC and then exchanges it for the relinquished property when the latter is sold.
- Improvement exchange:
- An improvement exchange is a form of exchange where the taxpayer identifies, purchases and improves a property to their specifications within the 180-day time period. This can be through either a deferred exchange – the original property is sold first – or through a reverse exchange. A purchase vehicle – an “Exchange Accommodator Titleholder” (EAT) – is used, since a taxpayer cannot do a 1031 exchange with themself.
- Leasehold Improvement exchange:
- This is a more complex 1031 exchange involving long-term (30-year) leasehold interests that, for these purposes, qualify as ownership, or fee, interests.
- Simultaneous exchange:
- The simultaneous exchange involves the sale of the old property and the purchase of the new at the same closing or within hours/days. This type of exchange is one of the most common types of 1031 exchanges. This is permitted because the transaction has 180 days to close.
- Partial/“boot” exchange:
- Tax deferrals of 1031 exchanges are limited to exchanges where the original property is exchanged for one of equal or greater value. When that is not the case, the 1031 exchange may still occur, but the excess value not reinvested is characterized as “boot” and taxed as capital gain or recaptured depreciation.
Where to Watch Out
While 1031 exchanges are increasingly popular instruments, they can be complicated to execute on and entail a number of risks. Even the most sophisticated real estate investor can make mistakes.
The most critical element of the 1031 exchange is the iron-clad timing on the part of the IRS to execute on the deal. For example, after the business property is sold, all replacement properties must be specifically identified within 45 days.
Then, there are up to 180 days from the sale of the original property to acquire a replacement property or properties. The IRS is exceptionally strict on this point. If not followed exactly, the investor will pay capital gains tax and depreciation recapture.
An additional potential disadvantage is that the investor will not have access to the involved capital – not just capital gains, but the entire amount.
If, given the above, it seems that a 1031 may not be an appropriate choice, there are parallel structures that may be more attractive. An alternative, known as an Opportunity Zone Fund (OZ Fund), allows a taxpayer to reinvest just the gain in the fund, not the entire sales proceeds, and defer the tax on it (at least until the end of 2026 under current law which is subject to change in the future). Moreover, as an additional benefit those funds are not required to be reinvested in like-kind assets – i.e. they can be reinvested outside of real estate. This article is not intended to be a full discussion of Opportunity Zone Funds but one excellent long-term benefit of these investments can be that any gain from the newly invested funds is not taxable if held for 10 years or more.
Selecting the Right Qualified Intermediary
While a powerful instrument for investors, 1031 exchanges can hold hazards for the unwary. Fortunately, Fieldpoint Private’s experience and expertise with 1031 exchanges assure investors that they can proceed with confidence – our principal value proposition is to de-risk the process for our clients.
Firstly, Fieldpoint assists clients in diagnosing property purchases to avoid pitfalls and work through potential issues quickly. This is especially important due to the strict IRS time constraints. Many of our clients come to us with multiple target properties and our credit-trained bankers are able to give feedback almost immediately.
Choosing the right Qualified Intermediary is critically important in 1031 exchanges and it comes as a surprise that there is very little regulation in this area. Conducting due diligence is crucial in order to ensure the exchange funds will be held in a safe manner. Fieldpoint Private can advise on the selection process for choosing a Qualified Intermediary. A 1031 Qualified Intermediary, also known as an Accommodator, is an entity that facilitates 1031 exchanges. Generally, anyone who is related to the taxpayer, or who has had a financial relationship with the taxpayer – aside from providing routine financial services – within the two years prior to the close of escrow of the exchange is not permitted to serve as the Qualified Intermediary. This includes employees.
Accordingly, the taxpayer may only use his or her current attorney, accountant, investment banker, broker or real estate agent in exceptional circumstances. The role of the Qualified Intermediary is to enter into a written agreement with the taxpayer whereby the former transfers the relinquished property to the buyer and transfers the replacement property to the taxpayer pursuant to the exchange agreement.
The Qualified Intermediary subsequently holds the proceeds from the sale of the relinquished property in a trust or escrow account in order to ensure the Taxpayer never has actual or constructive receipt of the sale proceeds.
Fieldpoint Private has deep expertise in identifying and assessing potential Qualified Intermediaries. who can facilitate a 1031 exchange rapidly and safely.
1031 exchanges are often incorporated into other investment strategies. Fieldpoint Private can work with clients’ trusted advisors to integrate 1031 exchanges in their overall investment and estate planning strategies. For example, 1031 exchanges can have an important role in estate planning, as they allow for diversification of real estate assets which then can benefit from a step up in cost basis at death vs. incurring taxes while the donor was alive.
1031 Exchanges Are Complex, But They Don’t Have to Feel That Way
1031 exchanges are a practical vehicle for reducing tax exposure and moderating risk while increasing diversification in real estate investments. The many classes of 1031 exchanges give significant leeway to an investor to choose the format and the real estate investments most appropriate for their goals. However, given their complexity, in particular around tight timing from the IRS, it is of utmost importance to have a competent, trusted advisor to support the execution of the exchange. Fortunately, Fieldpoint Private has deep expertise in executing on successful 1031 exchanges, and can help design a potential exchange and facilitate the selection of a Qualified Intermediary, in addition to incorporating the exchange into a broader estate planning roadmap.
About Fieldpoint Private
Fieldpoint Private provides personalized and private commercial banking and trust services. Headquartered in Greenwich, Connecticut, with offices spanning the Northeast and Southeast, the bank has $1.4 billion in bank assets. Catering to RIA’s, successful individuals, families, entrepreneurs, businesses and institutions, Fieldpoint Private offers a reciprocal combination of private banking and business banking services, and where appropriate, personal trust capabilities. Through a comprehensive understanding of our clients’ individual financial circumstances Fieldpoint Private furnishes unbiased advice and personal service to free up the one resource that, regardless of means, no one can ever have enough of: time.
Banking Services: Fieldpoint Private Bank & Trust. Member FDIC. Registered Investment Advisors: Fieldpoint Private Securities, LLC, is a SEC Registered Investment Advisor and Broker Dealer. Member FINRA, MSRB, SIPC. Accounts managed by FPS are not FDIC insured. Trust services offered through Fieldpoint Private Trust, LLC, a public trust company chartered in South Dakota by the South Dakota Division of Banking.