A Real Estate Investor’s Guide to 1031 Exchanges

How does it work?

Successfully executing a 1031 Exchange requires careful planning and meticulous attention to detail as there are a number of IRS rules that need to be followed. One of the most important rules to note is the firm deadlines in which to complete a 1031 Exchange. Once the sale of the relinquished property closes, the seller has a total of 180 days, including 45 days to identify, document and submit a list of qualifying replacement properties, to close on the purchase of their replacement property or properties.

The seller is prohibited from taking possession of funds from the sale of the relinquished property. Funds must be held in escrow by a third party Qualified Intermediary (QI). In addition, funds can only be used to pay off a mortgage or deed of trust on the relinquished property and/or pay for the purchase and closings costs of the replacement property.

In order to fully optimize the benefits of a 1031 Exchange, a taxpayer needs to reinvest 100% of the net sales proceeds from the relinquished property, which includes both equity and debt. Any money from the sale that is used to pay off the mortgage or deed of trust on the relinquished property are deemed “realized proceeds” and are included in the total exchange value. What that means is that mortgage amount or realized proceeds must either be replaced with a new mortgage or cash when purchasing the replacement property.

Are the benefits worthwhile?

Going through the steps of a 1031 Exchange can be well worth the extra effort. As an example, a property owner is selling a 20-unit apartment building in New Jersey for $4 million.  He has a $500,000 mortgage that he pays off at closing. The property is a long-term hold and has seen significant appreciation, which will result in a $3 million capital gain. The federal taxes alone would result in a tax bill of $600,000 for an individual who is taxed at the current highest rate of 20%. State tax obligations will push that amount even higher.  

In order to defer those tax obligations, the taxpayer must complete a 1031 exchange and purchase a replacement property for $4 million or more (debt + equity from his replacement property).  He purchases 3 Dollar Generals for $9M as his replacement property.  By putting a 60% mortgage on the replacement property, he is able to buy multiple properties and grow his real estate portfolio, achieving greater income.  He defers his tax obligation and uses all of his net proceeds of $3.5 million as the down payment on the Dollar Generals.  

For many investors, the ability to defer capital gains taxes is a powerful incentive. However, each situation is unique. Would a 1031 Exchange still be worthwhile if the taxable capital gain was $60,000 instead of $600,000? Some taxpayers might have other losses they can use to offset the capital gain, or they may need to liquidate assets to pay other expenses. So, it is important for a property owner to consult with a tax advisor and do an analysis of how a sale would impact his or her own tax situation.

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