How 1031 exchanges can help property owners build net worth   

As a real estate broker, it’s important to understand the benefits of a 1031 tax deferred exchange, which is a common tax strategy savvy real estate investors use to help them increase net worth faster and more efficiently. The process, which is guided by a qualified intermediary or certified specialist, allows property sellers to shift their funds from the sold property to a new purchase or purchases without an obligation to pay capital gains taxes.

Elements of a 1031 tax deferred exchange

According to the Internal Revenue Service’s Code 1.1031(k), a person owning real estate for investment or business purposes can sell their property and then purchase “like-kind” property in order to defer paying their capital gains tax with the support of a qualified intermediary. The desired replacement property must be identified by the property owner, known as an exchanger at this point in the process, within 45 days. The new property must also be settled within 180 days of the date of settlement of the relinquished property.

  • Qualified Intermediary (QI): The QI has numerous roles throughout the process. Initially, the QI drafts the exchange agreement and assignment documents, documents that allow one party to transfer the rights and benefits of a contract to another party. The QI then accepts the assignments of all contracts associated with the exchange and notifies all parties of these assignments. From there, the QI provides instructions to the settlement agent, a professional who facilitates the transfer of real property in a purchase and sale. The QI also creates a qualified escrow account for the proceeds from the sale, eventually funding the settlement of the replacement property from the escrow account. The QI receives the required 45-day identification notice for the replacement property and handles the direct deeding issues. Finally, the QI prepares a comprehensive accounting of the funds placed in escrow and copies of all exchange and closing documents.      
  • “Like-kind” property: In order to qualify for a 1031 tax deferred exchange, the exchanger needs to find a property considered “like-kind.” “Like-kind” doesn’t refer to the grade or quality of a property but rather the property’s nature or character. For example, if your client owns a single-family rental property and wishes to purchase a farm as a replacement, that falls under the definition of “like-kind.” Exchanging a lot or condominium for an office building also meets those guidelines. The IRS has broadly defined that any kind of real estate may be exchanged for any other kind of real estate.

Replacement property requirements

A 1031 tax exchange also allows the exchanger to purchase replacement property using that portion of the proceeds that would normally be used to pay a capital gains tax. The replacement property must be of equal or greater value than the relinquished property and all cash equity from the sale must be reinvested to have no tax on the sale of the relinquished property. If the exchanger buys a property of lesser value, the difference of the two property values is subject to capital gains tax and unrecaptured depreciation tax.

Properties that don’t fall under the guidelines for a 1031 exchange are personal primary residences. Spec houses or properties designated for a quick turnaround (i.e. purchasing a home and completing quick improvements for immediate sale) are also not eligible for a tax deferred exchange.      

As a real estate broker, you may be in the best position to inform your clients about how 1031 exchanges can help them. However, in order to properly advise your client, it’s important to have a basic working knowledge of tax deferred exchanges. Despite stringent guidelines and restrictions, investment and business property owners can benefit greatly from utilizing this type of transaction.

About the Authors

Randy Kaston is the Director of Business Law Group at Ligris + Associates. Her practice concentrates on all aspects of commercial and residential transactions, including representing lenders in closing complex commercial, asset-based, real estate, construction, and SBA loans, as well as business lines of credit.

John Starling is the Senior Vice President of Northern Bank’s 1031 Exchange, LLC and helps people and business entities preserve profit and build wealth faster through Tax Deferred Exchange.