1031 Exhanges

A 1031 exchange refers to an investor selling one or more investment properties, and exchanging it/them to purchase another investment property or properties.  Many of Team Whitney’s clients ask about the difference between a 1031 exchange and the capital gains $250,000 and $500,000 tax exemptions.  The $250,000 and $500,000 capital gains tax exemption rules apply to a homeowner’s primary residence only, which we will discuss in more detail in a different blog.  Team Whitney’s recommended 1031 exchange company, Asset Preservation, Inc., also known as API, states the following below, and then we will look at an example to help simplify and explain their information:

“If a taxpayer intends to perform a 1031 exchange which is FULLY TAX-DEFFERED, they must meet two simple requirements:

1.      Reinvest the entire net equity (net proceeds) in one or more “like-kind” replacement properties; AND…

2.      Acquire one or more “like-kind” replacement properties with the same or a greater amount of debt.”

Asset Preservation, Inc. (API) goes on to add, “An alternative approach for a complete tax deferral is acquiring property of equal or greater value and spending the entire net equity in the acquisition. One exception to the second requirement is that a taxpayer can offset a reduction in debt by adding new cash to the replacement property closing in an amount that is the same or exceeds the reduction in debt.”

Let’s look at an example to explain the above rules, and assume an investor sells a multi-unit property in San Pedro for $2,200,000, and the investor’s net proceeds are $1,750,000.  In this example, let’s assume the current loan on the property is for $290,000.  If an investor utilizes option 1 above, the investor would need to reinvest the net proceeds of $1,750,000 + $290,000 of debt replacement, so the replacement property would need to be $2,040,000 or more.  If an investor utilizes option 2 above, the replacement property would need to be $2,200,000 or more, so in this example, the $2,040,000 number is the lower number to hit on the replacement property purchase price.  In either scenario, API confirmed that an investor can replace the debt with cash on hand, so an investor does not have to obtain financing again on the replacement property.     

Furthermore, the properties an investor is selling (the relinquished property) and purchasing (the replacement property) must be like-kind, and there are certain time limits an investor must adhere to.  In regards to like-kind, the definition is very broad.  For example, an investor can exchange vacant land in Rancho Palos Verdes for an industrial property in San Pedro, or exchange a commercial property in San Pedro for a residential property in Rancho Palos Verdes.  An investor cannot though, for example, exchange property for a coin collection.  Those are not considered like-kind.  Team Whitney’s clients have also asked about investing the proceeds of a 1031 exchange into a REIT (Real Estate Investment Trust) or into a DST (Delaware Statutory Trust).  According to our 1031 exchange company, API, an investor cannot do a 1031 exchange into a REIT, as it is not considered real property, BUT, an investor can do a 1031 exchange into a DST.  API went on to say an investor can potentially transfer from the DST into a REIT as soon as 1-2 years later using a 721 Exchange.  It is always recommended to have a financial advisor assist with this process.  

In regards to time limits, an investor has up to 45 days after closing escrow on the property that is sold (the relinquished property) to identify up to 3 replacement properties the investor will be potentially purchasing in the exchange.  If Team Whitney represents an investor as a Seller, we will recommend making the sale of the investment property contingent on the investor securing a replacement property during the escrow period.  We do not want to close the sale escrow with the possibility of an investor not being able to secure a replacement property within 45 days after closing.  One of the three properties an investor selects must close escrow within 180 days after the close of escrow of the relinquished property.  There are a few other ways to identify property instead of using the 3-property rule Team Whitney can discuss at a personal consultation.  The most common way to identify properties is by using the 3-property rule, so that is the one we used here for purposes of this discussion.  An investor is also allowed to sell a few properties and pool the money together to buy a larger property, or an investor can also do the reverse, and sell a large property to buy several smaller properties. 

Another option investors have is to perform a reverse 1031 exchange, whereby an investor would purchase the replacement property before selling the relinquished property.  In order to do this, an investor would need to have the funds available to buy the replacement property without utilizing the proceeds from the sale of the relinquished property, which usually isn’t possible, unless an investor has additional liquid funds. 

In regards to fees for an exchange, in 2023, API charges $1,250 for the first property being sold in the exchange, and then $200 for each additional property that is sold as a part of the exchange.  The $200 fee only applies if an investor sells all of the properties at the same time.  If another exchange is done a year later, for example, a new $1,250 fee applies.  Also, reverse exchanges are more expensive, and quoted on a case-by-case basis.   

In a 1031 exchange, an investor will not receive the proceeds directly from the sale of the investment property or properties.  The proceeds will go to a qualified intermediary (like API) who will hold the funds, and then transfer them directly to the escrow company for the purchase of the new investment property.  If an investor plans on completing a 1031 exchange (or a reverse 1031 exchange), it is important to hire a real estate team who is not only knowledgeable on the process, but also a team who will put the necessary protections in place for an investor to avoid capital gains taxes.  For more information or to set up a personal consultation, please contact Danielle Whitney Moore with Team Whitney (Keller Williams Realty L.A. Harbor) at (310) 987-9103.