1031 Exchanges
In California, a §1031 exchange allows you, as a real estate investor, to defer the federal and state income tax that would normally be incurred from selling real property, by using the proceeds of the sale to immediately purchase another ‘like-kind’ property.
Like-kind properties in a is a broad description of properties that are defined by the IRS as “the same nature or character, even if they differ in grade or quality.” In terms of a §1031 exchange, this means that any type of investment property can be exchanged for any other type of investment property, with the exception of any personal property (such as your primary residence or vacation home) which is not eligible for this type of trade.
This allows you to shift the focus of your investments, for example, transitioning from high-maintenance investments to low-maintenance investment properties or if you want to move your investments from one state to another, without income tax ramifications.
The primary concept of a traditional §1031 exchange is that one property is swapped for another and deferring federal or state income tax on gains that could potentially be due in the case of a non-exchange sale.
It’s generally unlikely to find a property that you want to buy (an out-of-state or California replacement property) that is owned by someone who wants the property that you have (the property you will relinquish). There are several subtypes of §1031 exchanges, including delayed or three-party exchanges. These types of exchanges give you some leeway as far as transferring your equity from one property to another using a §1031 exchange.
1031 Exchanges in 2023
As part of President Biden’s 2023 budget, the administration proposed severe limitations to 1031 exchanges. The proposal would allow taxpayers to defer up to $500,000 of capital gains ($1 million in the case of married individuals filing a joint return) for each sale of investment property. Any gains in excess of $500,000 (or $1 million, as the case may be) would be recognized by the taxpayer in the year the real property is sold.
President Biden’s proposal would, of course, severely limit the property values that investors can use in an exchange. However, it would also adversely impact the economy as a whole. While this proposal is intended to generate $1.95 billion in revenue for the government through taxing the sale of investment real estate, other businesses that generate income as a result of 1031 exchanges were estimated to have produced approximately $7.8 billion in tax revenue last year, according to a May 2021 study by Ernst & Young.
There are numerous ancillary parties involved throughout the 1031 exchange process, including real estate investors, escrow specialists, qualified intermediaries, lenders, attorneys, and appraisers. In total, the Ernst & Young study projected that businesses related to 1031 exchanges would produce 568,000 jobs, create $27.5 billion of labor income and add $55.3 billion to GDP during the course of last year. As a result, if exchanges are limited as President Biden proposes, the negative impact would extend far beyond the prospective sellers.
“Given the overall economic impact of Section 1031, I think it is doubtful that Congress would enact such an aggressive cap on 1031 exchanges,” says Kevin M. Levine, Partner and Executive Vice President at Peak 1031 Exchange. “However, we also should not take it for granted that Section 1031 will remain intact as it now is. Each one of us must do our part to ensure that we and the economy as a whole can continue to reap the full benefits of 1031 exchanges.”
As a result, we at Peak 1031 Exchange encourage readers to contact their representatives and express their concerns about limiting IRC Section 1031 in the manner described above.
Please speak with your tax advisor and contact me to refer you to QI, a 1031 exchange expert. Source: © 2023 Peak 1031 Exchange, Inc.
4 Most Common 1031 Exchanges
In this article, we will explore the four primary types of §1031 exchanges, which are as follows:
Simultaneous Exchange A simultaneous exchange involves closing the sale of the relinquished property and the replacement property on the same day without any delay. This type of exchange is less popular due to the difficulty of coordinating the sale and closing of both properties. It can occur through a two-party trade, a three-party exchange, or a qualified intermediary.
Reverse Exchange A reverse exchange, also known as a forward exchange, is when you purchase the replacement property before selling your relinquished property. This type of exchange is more complicated as you must use personal funds or a bank loan to acquire the replacement property before selling the downleg. The replacement property must be acquired from the exchange accommodation titleholder and must be identified within 45 days of the closing of the replacement property. The sale of the relinquished property must be closed within 180 days of the closing of the replacement property.
Construction or Improvement Exchange This type of exchange allows you to use the equity from the sale of your relinquished property to purchase and improve the replacement property while the qualified intermediary holds the deed. The entire exchange equity must be used to purchase and complete the construction of the replacement property within 180 days to avoid paying federal and state income tax. The replacement property must be worth equal or greater value when deeded to you than when identified for the exchange. It is important to note that any labor or material charges incurred as part of the construction process are not considered ‘like-kind’ with respect to real estate.
Personal Property Exchange A personal property exchange involves exchanging personal property for other personal property of like-kind or like-class. This type of exchange is subject to certain limitations and rules.
It is important to consult a tax professional to ensure that your exchange qualifies for tax-deferral under §1031 of the Internal Revenue Code.