Fundamentally, a 1031 exchange is a tax deferral strategy. Other benefits can include portfolio consolidation or diversification, increasing property cash yield, or investment management relief (e.g. exchanging a multi-family property for a single tenant NNN investment). 1031 exchanges allow owners to defer the capital gains taxes associated with the sale of property. For example, if an investor purchases a building for $3 million and later sells it for $5 million, that investor can defer paying taxes on the $2 million capital gain if they enter into a 1031 exchange.
Through a Qualified Intermediary, an investor uses proceeds from Relinquished Property as the medium for the transaction. Relinquished Property is property sold by a taxpayer in a 1031 exchange, commonly referred to as the Downleg. The total debt and equity of the Replacement Property must be equal to or exceed the total debt and equity of the relinquished property. Replacement Property is property being purchased by the taxpayer in a 1031 exchange, also known as the Upleg. The key benefit of an exchange is that the investor is permitted to defer the 20-25% capital gains tax payments that would accompany a conventional sale.
All 1031 exchanges revolve around two crucial deadlines. Within 45 days of closing on Relinquished Property, an investor utilizing section 1031 must research and submit a list of possible replacement properties with a qualified intermediary (QI)- a firm certified to act as the closing agent for 1031 exchanges. This 45-day period is known as the Identification Period, or ID Period. The two most commonly used property identification rules are the 3-Property Rule and the 200-Percent Rule. The 3-Property Rule articulates that 3 properties can be identified without regard to each Replacement Property’s respective fair market value, while the 200-Percent Rule allows any number of Replacement Properties to be identified, so long as their aggregate fair market value does not exceed 200% of the fair market value of all Relinquished Properties. Either rule can be chosen by an investor utilizing section 1031, but the investor must adhere to one rule only. The second deadline occurs 180 days after the sale of Relinquished Property. This 180-day period is commonly referred to as the Exchange Period. At that time, the investor utilizing section 1031 must close on a Replacement Property, using debt and equity equal to or greater than the debt and equity of the Relinquished Property. If either deadline is missed, the investor will be required to pay capital gains taxes to the IRS.
In light of the deadlines that can complicate exchanges and the stringencies thereof, a professional community of 1031 advisors and consultants has emerged over the years. These advisors include qualified intermediaries (QIs), real estate brokers, net-leasing firms that help exchangers locate replacement properties, and accountants and attorneys that provide specialized tax advice related to 1031 transactions. The larger and more complex the 1031 transaction, the more important comprehensive expertise becomes.