Types of 1031 Exchanges
A 1031 exchange is a strategy for deferring capital gains taxes on the sale of investment or business property. Under normal circumstances, when you sell a property and make a profit (capital gain), you are required to pay capital gains taxes on that profit. However, Section 1031 of the Internal Revenue Code allows investors to defer these taxes if they reinvest the proceeds from the sale into a like-kind property within certain time frames. In the meantime, the proceeds must be “parked” with a qualified intermediary (“QI”).
The properties involved in a delayed 1031 exchange must be “like-kind” properties, which in practice simply means that they both must be income-generating investment or owner-occupied property, even if they differ in grade or quality. For example, you could exchange a residential rental property for a commercial property or vacant land.
To ensure compliance with the 1031 exchange rules and to maximize the tax benefits, it is advisable to work with a qualified intermediary (QI) or a 1031 exchange facilitator who can help facilitate the exchange process and handle the required documentation and funds.
One reason to work with a 1031 exchange facilitator like Birmingham Exchange Company, both in the context of a specific transaction and more generally, is that the 1031 exchange process can work in several different ways, allowing the 1031 strategy to be tailored to your specific situation. Below are some common types of 1031 exchanges, illustrating the flexibility and customizability of the process.
A delayed 1031 exchange is the most common, and logistically the simplest, form of 1031 exchange. In a delayed 1031 exchange, the investor first sells their property as normally, and then identifies and closes on a replacement property at a later date.
The investor must identify replacement properties within 45 days of the sale. The investor must then complete the purchase of the replacement property or properties within 180 days of the sale. By following these guidelines, the investor can defer the capital gains taxes that would normally be due on the sale.
In a traditional 1031 exchange, an investor sells the relinquished property and uses the proceeds to acquire a replacement property within a specific timeframe. By doing so, the investor can defer paying capital gains taxes that would typically be due upon the sale of the relinquished property.
In a reverse 1031 exchange, the sequence is reversed. The investor first acquires a replacement property before selling their relinquished property. This approach is useful when an investor has already identified a desirable replacement property but has not yet found a buyer for their current property.
To successfully execute a Reverse 1031 exchange, a special purpose entity (referred to as an exchange accommodation titleholder or EAT) must hold title to either the relinquished or replacement property during the exchange process. The EAT acts as an intermediary and facilitates the exchange.
Here’s an overview of how a reverse 1031 exchange generally works:
- Purchase of Replacement Property: The investor closes on the purchase of their intended replacement property and enters into a 1031 exchange. Funds needed for the purchase are either borrowed or are paid by the investor out-of-pocket. Under the 1031 regulations, the investor may not hold title to both properties (the replacement property and the relinquished property) at the same time, so at this time the replacement property is parked with a third party called an exchange accommodation titleholder or EAT.
- Sale of Relinquished Property: The investor has up to 180 days from the acquisition of the replacement property to complete the sale of its relinquished property. (The 45-day identification deadline does not apply here, since the property was identified before step 1.) At closing on the sale, the QI receives the sale proceeds.
- Resolve Phase: Once the relinquished property has been sold, the EAT transfers ownership of the replacement property to the investor, and the QI remits the sale proceeds from the relinquished property to the investor, finalizing the 1031 exchange.
Parking the replacement property with the EAT sometimes presents problems for the investor, especially if it’s borrowing money to acquire it, but the reverse 1031 exchange also works if the investor parks the relinquished property with the EAT instead:
- Sale of Relinquished Property, part 1: in this version of a reverse 1031 exchange, the investor begins by transferring ownership the relinquished property out of its name and into the EAT.
- Purchase of Replacement Property: The investor then closes on the purchase of their intended replacement property in its own name. Funds needed for the purchase are either borrowed or are paid by the investor out-of-pocket.
- Sale of Relinquished Property, part 2: The investor has up to 180 days from the acquisition of the replacement property to complete the sale of its relinquished property. (The 45-day identification deadline does not apply here, since the property was identified before step 1.) At the closing on the sale, the EAT deeds over the property to the buyer, and the QI receives the sale proceeds.
- Resolve Phase: Once the relinquished property has been sold, the QI remits the sale proceeds from the relinquished property to the investor, finalizing the 1031 exchange.
A “combo” or “mixed” 1031 exchange combines elements of both a delayed exchange and a reverse exchange. Because the investor can both sell and buy multiple properties as part of a 1031 exchange, there may be several transactions ongoing at once, and the closings may take place in several different orders. For example, the investor may need to purchase a replacement property before selling a relinquished property, and then purchasing a second replacement property afterwards. The 1031 exchange rules are flexible enough to accommodate this.
It’s important to note that the investor must still satisfy the requirements for a valid 1031 exchange as to the transaction as a whole, including the identification and exchange periods, as well as ensuring the replacement property is of like-kind. Most importantly, for the combo 1031 exchange to qualify, the last transaction must close within 180 days of the first transaction.
To ensure compliance with the 1031 exchange rules and to maximize the tax benefits, it is advisable to work with a qualified intermediary (QI) or a tax professional who specializes in 1031 exchanges. They can provide guidance tailored to your specific situation and help facilitate the transaction.
An improvement 1031 exchange, also known as a construction or “build-to-suit” exchange, allows the investor to buy a replacement property below the value of its relinquished property, and then do work to the replacement property to improve it and increase its value.
In an improvement 1031 exchange, the investor identifies a replacement property that requires construction, renovation, or improvements to meet their specific needs or investment objectives. Instead of acquiring a fully completed replacement property, the investor uses the exchange funds to make the necessary improvements or construct a new building on the replacement property. While construction is taking place, the replacement property is parked with the EAT, so that when the investor eventually takes title, it will be to the improved, more valuable property, and the deed will reflect the work the investor has done to the property.
Here’s an overview of how an improvement 1031 exchange generally works:
- Sale of Relinquished Property: The investor sells its relinquished property and enters into a 1031 exchange. The sale proceeds are parked with a QI.
- Purchase of Replacement Property: The investor identifies and closes on the replacement property. The QI pays the seller, and title to the property is parked with the EAT.
- Construction/Improvement Phase: After acquiring the replacement property, the investor uses the exchange funds to carry out the necessary construction, renovation, or improvements. This phase may involve working with contractors, obtaining permits, and overseeing the construction process. Funds needed for construction are either paid by the investor out of pocket, or paid by the QI directly to contractors.
- Resolve Phase: Once the improvements are complete, the EAT transfers ownership of the replacement property to the investor, and the QI releases any remaining parked funds.
The improvements or construction must be significant and add value to the replacement property. Merely cosmetic changes or routine repairs may not meet the requirements of an improvement 1031 exchange. It’s also important to note that the entire process must still take place within the 180 day period required by 1031 rules. The investor should consult with tax professionals and legal advisors to ensure compliance with the IRS guidelines.
Land Contract Exchange
In a land contract 1031 exchange, the investor enters into an agreement with the buyer of their relinquished property, known as the vendee, whereby the vendee agrees to make installment payments over a specified period of time. Instead of receiving the full proceeds from the sale upfront, the investor receives the funds over time as installment payments. The 1031 process is flexible enough to accommodate this, with some important considerations the investor should be aware of.
Here’s an overview of how a land contract 1031 exchange generally works:
- Sale of Relinquished Property: The investor sells their relinquished property to the buyer (vendee) under a land contract or installment sale agreement. The investor and the vendee establish the terms of the land contract, including the purchase price, payment schedule, interest rate, and duration of the contract. The downpayment, if any, goes to the QI. The principal portion of any payments made within 180 days after the closing also goes to the QI.
- Purchase of Replacement Property: The investor identifies and closes on replacement properties within the 45 and 180 day periods required by the 1031 exchange rules. The funds to purchase the replacement property may come from the QI, to the extent the QI is holding funds, or from the investor (out-of-pocket or borrowed).
- Resolve Phase: Once the 180 day period has ended, the QI remits the remainder of the parked land contract payments to the investor, finalizing the 1031 exchange.
It’s important to note that the use of a land contract or installment sale agreement in a 1031 exchange requires careful planning and consideration. The structure and terms of the land contract should comply with the IRS guidelines for 1031 exchanges.