1031 Exchanges: A Crash Course

First, Exactly What is a 1031 Exchange?

Simply put, a 1031 exchange allows a property owner to defer payment of capital gains by using the proceeds from the sale of an investment property to purchase a similar replacement property. Because Hawai`i has such a high percentage of investment properties, the 1031 tax-deferred exchange is a fairly common practice here – and a powerful way to leverage real estate to build wealth.

There are no limits on how frequently 1031 exchanges can take place, which means that property owners can choose to trade one piece of investment real estate for another as often as they’d like. Rather than cashing in on the profits from each sale, they can continue to roll them into successive real estate investments. In this way, the initial investment continues to grow, tax-deferred, and potentially more quickly than if the owner simply held onto the original property.

Next, Some Specifics to Keep in Mind

Section 1031 of the Internal Revenue Code does specify that:

1. The property being sold (usually referred to as the relinquished property) and the replacement property must meet a “qualified use standard,” meaning that they have a business, trade, or investment use. A residential rental property, a commercial office building, or even a vacant piece of land might meet this standard.
2. The exchange must involve “like kind” real property; that is, each property is held for business or investment purposes rather than serving as a personal residence. “Like kind” has a broad interpretation, though. A rental property can be exchanged for an office building, for example, or an office building exchanged for vacant land. Also, the involved properties do not have to be in the same state.
3. The replacement property must be of equal or greater value than the relinquished property (the value being the sales price minus closing costs). Note: one property can be exchanged for two or more properties – or two or more properties can be exchanged for one property – as long as the replacement property value is higher than the relinquished. If not, capital gains taxes will be owed on the difference.

Other Important Points

A replacement property has to be identified in writing within 45 days of closing on the sale of the relinquished property. Typically, more than one potential replacement property is identified, in case one falls out of escrow. Closing on an identified replacement property must occur within 180 days of the relinquished property’s closing.

Additionally, the taxpayer(s) who relinquish property must be the same as the taxpayer(s) who replace it. For example, if two spouses’ names are on the title of an existing property, both spouses’ names have to appear on the title of the new one, as well.

For a second/vacation home to be involved in a 1031 as a replacement property, it has to be owned by the taxpayer for at least 24 months immediately following the exchange. During each of the two 12-month periods within that 24 months, the owners must rent it to another party at fair rental value for 14 or more days, and the owners may not use the property themselves for more than 14 days (or more than 10% of the number of days rented, if it is rented for more than 14 days).

For a leasehold property to be involved in a 1031 exchange, it must have at least 30 years remaining before the lease expires.

Types of Exchanges

In a delayed exchange, a period of 180 days is allowed between the relinquishing of one property and its replacement with a new property. During that period, the proceeds from the sale of the relinquished property are held by a “qualified intermediary,” such as a title company. This arrangement ensures that the taxpayer does not actually receive the funds before they’re reinvested into the new property.

In a reverse exchange, the replacement property is purchased before the relinquished property is sold. Funds are sent to an exchange accommodation titleholder (EAT), who purchases the new property. When the current property is sold, a qualified intermediary uses the proceeds to buy the replacement property from the EAT. A 180-day timeframe still applies.

In a simultaneous exchange, the relinquished and replacement properties close at the same time. A qualified intermediary is still required.

In an improvement exchange, the EAT holds the replacement property’s title while exchange funds are used to make improvements on it. For this type of exchange to take place, the improvements must be completed within the 180-day timeline.

Final Thoughts

At first glance, a 1031 exchange may look complicated – but knowledgeable professionals can help navigate the ins and outs! A qualified intermediary like a title and escrow company coordinates the transaction by preparing the paperwork, consulting with the investor’s tax advisor as needed, monitoring timelines, executing closing documents, and ensuring that funds are disbursed correctly.

And of course, an experienced real estate agent can serve as a guide through the process of selling the existing property and identifying replacement options, answering all of your questions along the way. If you’d like to talk more about 1031 exchanges, contact me today!

Leslie MacKenzie Smith, REALTOR(S), RS-42147