The fundamentals of a 1031 exchange transaction - by Pierre Debbas

Pierre Debbas, Romer Debbas, LLP

A 1031 exchange is a tremendous mechanism that real estate investors can utilize to defer their capital gains tax (on both state and federal levels which are approximately 8.8% and 20% respectively). This deferment enables an investor to increase the equity they have available to invest in properties which can result in the investor accumulating a much larger portfolio in comparison to not taking advantage of a 1031. A 1031 can become rather complicated in certain circumstances, but a general straight forward 1031 is mechanical and below are the three main fundamentals one should know about a 1031.

1. “Like-Kind Exchange:” A 1031 is defined as a “like-kind exchange.” This means that the properties the investor is selling and buying, must be a like-kind property. “Like-kind” is a federal tax term relating to the nature or character of the real estate in the hands of the owner meaning that the properties are used for investment or business purposes. Second homes and primary residences do not qualify for a 1031 exchange. Qualified real estate located in the 50 U.S. is of like-kind when exchanged for other qualified real estate located in the 50 U.S. and the U.S. Virgin Islands. Foreign real estate does not qualify as like-kind property. A 1031 exchange can have a residential property and commercial property as the relinquished and replacement property (defined below) as well as vice versa.

2. Notification (45 Days): The sale of an investment property is labeled as the “relinquished property” and the property to be purchased as a result of the 1031 is a “replacement property.” Once the closing for the relinquished property has taken place, all funds (with the exception of adjustments) have to be made out to a 3^rd party 1031 intermediary and the intermediary holds those funds in escrow. The investor then has 45 days from the date of the closing of the relinquished property to notify the intermediary of its intended replacement property or properties. There are three ways in which one can identify a property: 1) Three-Property Rule (most common) where the maximum number of replacement properties you may identify is three properties without regard to the fair market values of the properties; 2) 200 Percent Rule (fairly utilized) where you may identify any number of properties as long as their total fair market value does not exceed 200 percent of the total fair market value of all relinquished properties, and 3) 95 Percent Rule (least common and most complex) where there is no limit as to the total (aggregate) number or value of identified like-kind replacement properties permitted under the 95% exception as long as you actually acquire and close on 95% of the value identified.

3. Closing of Replacement Property (180 days): The closing of the replacement property must take place within 180 days from the sale of the relinquished property. All of the proceeds from the sale must be used on the purchase of the replacement property. The proceeds from the sale can be used to pay a portion of the purchase price of multiple replacement properties with the rest of the purchase price being financed or paid by the investor themselves, as long as all of the proceeds from the sale are used to purchase like-kind property within the 180 day period. A partial exchange is permissible. In this situation the investor will pay capital gains on whatever money they pull out for themselves and the money that they intend on using for the 1031 exchange must be held by the qualified intermediary.

Pierre Debbas, Esq. is a founding partner at Romer Debbas, LLP, New York, N.Y.