1031 Exchange - Overview and Analysis Tool

A 1031 Exchange, or Like-kind Exchange, is a strategy in which a real estate investor can defer both capital gains tax and depreciation recapture tax upon the sale of a property and use that money, which has not been taxed, to purchase a like-kind property.

Important Note: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

THE ADVANTAGES OF THE 1031 EXCHANGE

Using a 1031 Exchange allows a real estate investor to have significantly more equity available to purchase a desired property; through disposing of a real estate asset and deferring taxes, the exchanger (as we will be referring to them) has the entirety of the proceeds of a sale with no taxes taken out less expenses to use in the purchase of a new property.

An Example

Let’s take a look at the example below:

Focus on the last three rows where we can see that the 1031 Exchange option has given the exchanger $1.74 million, or 21.9%, additional dollars to use in the acquisition of a future property. Please watch the video below for a brief walk through and more details:

Additionally, if you’d like to run some scenarios yourself, please feel free to download the template below:

FINALLY PAYING THE DEFERRED TAXES, OR NOT

There is one way that I am aware of where a person can escape paying these taxes at a future date and as a result, many people use this advantage as a way of estate planning. If you die, and the real estate is passed on, the depreciated basis is effectively wiped away and the building is revalued at today’s fair market value. This is referred to as a stepped up basis. This effectively means the entity that has inherited the property is not responsible for the taxes due on the recapture of the depreciation or capital gains and the cost basis is reset to the market value at the time of the transaction.

AN EXAMPLE FOR FURTHER CLARIFICATION

Mr. Smith bought a property with an initial cost basis of $5 million dollars. Many years later, Mr. Smith dies and his daughter inherits the property, which now has an adjusted cost basis of $2.5 million and a fair market value of $10 million. If Mr. Smith’s daughter was to sell that building with no stepped up basis rule in effect, she would essentially have to pay depreciation recapture tax on $2.5 million ($5 million less the adjusted cost basis of $2.5 million) and capital gains tax on $5 million ($10 million of sale price less $5 million o original purchase price). However, with the stepped up basis rule, the cost basis is now $10 million, which means there is now no gain on the sale in the eyes of the IRS. She can now sell the building at $10 million and essentially pay no capital gains or depreciation recapture tax!

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WHAT QUALIFIES PROPERTIES TO BE ‘LIKE-KIND’ IN A 1031 EXCHANGE?

According to the IRS, both properties must be held for use in a trade or business or for investment. These properties do not need to be the same in size, value, or asset type.

EXCLUSIONS AND EXCEPTIONS

Personal residences cannot be considered for a 1031 exchange.
Property within the United States is not like-kind with property outside the United States.

EXAMPLES OF LIKE-KIND PROPERTIES THAT CAN BE EXCHANGED WITH ONE ANOTHER:

Office buildings
Retail shopping centers
Agricultural land
Rental homes
Single tenant NNN properties
Vacant land
Self storage facilities
Manufacturing plants
Apartment complexes

Essentially, an office building can be exchanged for land, a shopping center for a self storage facility, etc.

HOW DOES A 1031 EXCHANGE WORK

In order to qualify for a 1031 Exchange, a seller of real estate must successfully sell their property, and within a certain amount of time, identify and purchase another property or properties with the funds from the sale. There are strict rules to follow and any deviation may negate ones ability to successfully take advantage of a 1031 Exchange.

RULES FOR A 1031 EXCHANGE

TIME

These time parameters must be followed exactly. There is no allowable extension of time unless there is a presidentially declared disaster.

Upon the day of sale, the exchanger will have exactly 45 days to identify other properties and notify the potential seller of the intent to purchase.
- To officially identify a property, the exchanger must notify the potential seller in writing and clearly describe the property of interest with the address, description of the property, and name (if applicable). The exchanger must also sign this document.
Upon whichever is earlier of (1) the day of sale OR , (2) the income tax return due date for the year in which the property was sold; the entity seeking a 1031 exchange will have exactly 180 days to complete the acquisition of the next property, or properties, and this property must be similar to those identified during the 45 day window.

IDENTIFYING LIKE-KIND PROPERTIES

There are one of three rules to follow when identifying like-kind properties. A person electing to go through a 1031 Exchange needs to follow ONLY one:

3 Property Rule – The replacement properties identified are 3 or less.
200% Rule – The replacement properties can be an unlimited number of replacement properties as long as the aggregate fair market value of all properties identified is less than 200% of the value of the disposed property.
95% Rule – The replacement properties can be an unlimited number of properties as long as the final properties acquired are equal to at least 95% of the properties initially identified.

THE INTERMEDIARY: THE ENTITY SEEKING A 1031 EXCHANGE SHOULD NEVER CONTROL THE PROCEEDS AT ANY TIME BEFORE THE EXCHANGE IS COMPLETED

Every 1031 Exchange needs a Qualified Intermediary (“QI”). A Qualified Intermediary is not a regulated term and needs to be chosen by the exchanger and be someone he or she can trust to both get the job done and securely manage the process. There must be an agreement in writing between the exchanger and QI before the closing of the property being relinquished in the exchange.

The concept is that at no point should the exchanger be in receipt of funds from the sale and therefore should be removed from the direct transactional parts of the exchange until things have been wrapped up. The IRS’ view is that since our exchanger is never actually cashing out on the investment in the ownership of real estate, there is no taxable event, and if the exchanger ever comes into possession of the proceeds it is as if he or she sold the property and the 1031 exchange is no longer an option.

A qualified intermediary essentially acquires the relinquished property from the exchanger, sells it to a new buyer, uses the proceeds from the sale to purchase the replacement properties on behalf of the exchanger and then transfers the properties back to the exchanger. However, the QI, at no point, is the owner of any of the properties.

People who are disqualified from being intermediaries are as follows (direct from the IRS website):

Yourself or your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years.

WILL THE 1031 EXCHANGE BE AROUND FOREVER?

The fate of the 1031 Exchange in the long term is anyone’s guess. Congress has the authority to abolish the tax break at any time and there have been discussions about doing so over the past decade or so. However, the 1031 Exchange, which has been around since 1921, has survived the recent tax overhaul and appears to be secure in the near term.

Compatibility

This version of the tool is only compatible with Excel 2013, Excel 2016, and Excel 365.

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Version Notes

v1.0

Initial release

Frequently Asked Questions about the 1031 Exchange – Overview and Analysis Tool

What is a 1031 Exchange?

A 1031 Exchange, also called a Like-Kind Exchange, is a strategy where a real estate investor defers capital gains and depreciation recapture tax by using the proceeds from a property sale to purchase a like-kind investment property.

What is the main benefit of a 1031 Exchange?

It allows the exchanger to reinvest the full proceeds from a property sale—without immediate tax liability—into another property. As stated, “the exchanger has the entirety of the proceeds of a sale with no taxes taken out less expenses to use in the purchase.”

How can taxes be permanently avoided in a 1031 Exchange?

If the exchanger dies and passes on the property, the cost basis is reset to fair market value via a stepped-up basis, eliminating the capital gains and depreciation recapture tax burden for the inheritor.

What qualifies properties as “like-kind” in a 1031 Exchange?

According to the IRS, both properties must be “held for use in a trade or business or for investment.” They do not need to be identical in type, size, or value. Examples include office buildings, rental homes, land, and storage facilities.

What are the critical time limits for completing a 1031 Exchange?

45 days to identify replacement properties after sale

180 days to complete the acquisition of the new property
These timeframes are strict and cannot be extended, except in the case of a presidential disaster declaration.

What are the identification rules for replacement properties?

You must follow one of the following:

3 Property Rule – Identify up to 3 properties

200% Rule – Identify any number of properties with combined value under 200% of the relinquished property’s value

95% Rule – Acquire at least 95% of identified properties in value

What is the role of the Qualified Intermediary (QI)?

A QI facilitates the exchange by holding and transferring proceeds and replacement properties on behalf of the exchanger. The exchanger must not take possession of the proceeds. Disqualified parties include your broker, attorney, or anyone who worked for you in the last two years.

What types of property are excluded from a 1031 Exchange?

Personal residences

Foreign property (U.S. and non-U.S. properties are not like-kind)
Only investment or business-use property located in the U.S. qualifies.

How much more can an exchanger typically reinvest by using a 1031 Exchange?

In the example provided, using a 1031 Exchange gave the exchanger $1.74 million (21.9%) more to reinvest in a new property, compared to paying taxes upfront on the sale proceeds.

Is the 1031 Exchange likely to remain a viable strategy?

While its long-term future is uncertain and subject to congressional change, the 1031 Exchange has existed since 1921 and “has survived the recent tax overhaul,” suggesting it remains viable for now.

About the Author: Michael has spent a decade working in various capacities on more than $7 billion of real estate transactions spanning all asset classes and geographies throughout the USA. Michael is both the founder of Firm Ridge Real Estate, which has a core focus on niche and emerging real estate strategies and A.CRE Consulting, a real estate advisory and financial modeling firm that has provided services on projects totaling more than $21 billion to date. Prior, Michael was a founding member and COO of Stablewood Properties, an institutionally backed real estate operator. And before Stablewood, Michael was at Hines in San Francisco. Michael has both an MBA and Master in Real Estate with a concentration in Real Estate Finance from Cornell University.

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1031 Exchange – Overview and Analysis Tool