by Trevor Calton
The 1031 Exchange is a tax deferral strategy that allows an investor to relinquish a business or an investment asset and acquire another asset without having to pay capital gains taxes, or effectively deferring the capital gains taxes.
It's a little bit of a complicated process, but it makes a lot of sense, and the 1031 Exchange is actually one of the most beneficial advantages to a real estate investor in terms of tax benefits. It allows the investor to keep their capital invested throughout the lifetime of their investment career without having to take portions of it and pay capital gains taxes with it. Let's go over how it works.
In a typical buy-sell transaction, the investor would receive cash from the buyer in exchange for the deed in the sale. At that point, a portion of that money would need to go to the IRS in the form of capital gains taxes, assuming that the seller/investor made a profit and had some appreciation in the transaction. If you had, say, a $1 million gain and were paying a 35% tax rate on capital gains between state and federal, then the taxpayer would be liable for approximately $350,000 to the IRS. Well, moving forward, that $350,000 could be translated into another $1.4 million in purchase price if that investor was leveraging at 75%. So they could buy $1.4 million less real estate because of the capital gains liability.
The 1031 Exchange came about because an investor named Starker wanted to trade lands for other real estate and felt like because there wasn't a capital gain that was realized, he shouldn't be liable for the taxes. Originally, and still to this day, a one-for-one deed swap between two real estate owners qualifies and does not trigger any sort of capital gains liability.
But it's very difficult and extremely rare to find two sellers who want to exchange properties from each other, especially at the same time. So what happens is called a "Delayed Exchange." The delayed exchange gives the investor the opportunity to sell one property and then, within a certain timeframe, find another property from a different seller and invest in that without having to pay capital gains taxes.
I'll explain this a little more closely. An investor wants to sell to buyer and buy from seller. In order to qualify for a 1031 Exchange, there can be no money that goes from the buyer to the investor. The IRS allows is what's called a "Qualified Intermediary" -- somebody who is arm's-length from the transaction, typically a 1031 Exchange company or other professionals, that can act as a neutral third party.
When the investor wants to sell, they give the deed to the qualified intermediary. The qualified intermediary then gives that deed to the buyer, and the buyer gives the cash to them. Now, at this point, the qualified intermediary is holding on to the cash. As the investor is out looking for a new replacement property, if they find one, they instruct the intermediary to give the cash to the seller in exchange for the deed, and then the intermediary gives the deed back to the investor. This gives the investor the same effect on the exchange of the property as if they had just swapped deeds, because the investor never takes possession of the cash.
In the 1031 Exchange process, taking cash is called "Boot." As long as the investor does not receive any boot (in cash or debt relief) then they can avoid the capital gains taxes. There are certain components to this that you need to know. Let's go through them one by one.
The first thing to note is what is called the "Relinquished Property." That's the property that the exchanger is exchanging out of, sometimes the industry referred to as the "Downleg." When the investor goes to buy a new property, they buy what's called the "Replacement Property," or the "Upleg."
An important thing that the investor has to deal with is the exchange period and the timelines and deadlines that are set in that. The total exchange process can go 180 days. That means that the investor has six months from the day that they sell the relinquished property until the day they acquire the replacement property.
Even more crucial is what's called the "Identification Period," which is only 45 days. The investor must identify the potential replacement property (and they can identify up to three or maybe even more, depending on certain circumstances) within 45 days of selling the relinquished property, and then they have another 135 days to close, for a total of 180 days.
It may seem complicated, and in some sense it is; however, it is an extremely valuable tool for the investor to defer their capital gains taxes and keep that money growing in their investments.
Trevor T. Calton is and President of Evergreen Capital Advisors and the founder of Real Estate Finance Academy. Since 1997, he has analyzed, acquired, or sold more than $5 billion of commercial real estate assets, financed over 500 commercial investment properties, and overseen the asset management of over 6000 units of multifamily housing.