May 16, 2024

FAQs

Consider utilizing a 1031 exchange for many compelling reasons. As a starting point and resource to understand the basics and vocabulary of a 1031 exchange, we have received the following most frequently asked questions over the last ten years.

1031 FAQs

Since 1921, Federal tax law under Internal Revenue Code (IRC) section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. The taxes, which otherwise would have been due from the sale, are thus deferred. Most 1031 Exchanges involve separate buyers and sellers and are not simple swaps between two parties. Under these circumstances, the use of an independent third party Qualified Intermediary (QI) is necessary to satisfy the “exchange” requirement. The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any unused funds to the taxpayer at the end of the exchange. 1031 Exchanges must be completed within 180 days. Taxpayers recognize gain and pay tax on any unused funds or when they ultimately “cash out” of their property. In 2018, section 1031 was amended to provide that only real estate is eligible for a 1031 Exchange.

Like Kind Exchanges, also known as tax-deferred exchanges, are defined by IRC section 1031. Since 1921, section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. The taxes which otherwise would have been due from the sale are thus deferred. Section 1031 transactions range from 2-party “swaps” to more complex non-simultaneous 1031 Exchanges involving separate buyers and sellers. Qualifying assets include commercial, agricultural and rental real estate. Tax rules for non-simultaneous exchanges require the use of an independent third party Qualified Intermediary (QI). The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any unused funds to the taxpayer at the end of the exchange. Section 1031 Exchanges must be completed within 180 days. Taxpayers recognize gain and pay tax on any unused funds or when they ultimately “cash out” of their property.

All businesses, manufacturers, real estate investors, companies in the construction, trucking, rail, marine and equipment leasing industries, farmers, ranchers, individuals and more make good use of like-kind exchanges. 1031 Like-Kind Exchanges are one of the few incentives available to and used by taxpayers of all sizes. A recent industry survey showed that 60% of exchanges involve properties worth less than $1 million, and more than a third are worth less than $500,000. Qualified Intermediaries (QI) facilitate non-simultaneous tax-deferred exchanges of investment and business use properties for taxpayers of all sizes, from individuals of modest means to high net worth taxpayers and from small businesses to large entities.

Following a like-kind exchange, the owner of business use or investment real estate (“investor”) has more capital to acquire replacement real estate. This may result in increasing cash flow and/or increasing appreciation potential of the asset. In addition, the economy benefits because the investor cannot receive full tax deferral without fully reinvesting into the replacement property. The transactions generate taxable income in the form of title and escrow fees, real estate commissions, legal fees, and accounting fees as well as the purchase of goods and services if the replacement property is being improved. Local and state governments also benefit from fees and taxes which are generated by the real estate transactions. Since real estate located in foreign countries are not like-kind to real estate in the United States, section 1031 promotes reinvestment and job growth within our US borders.

With 1031 Exchanges, taxes are deferred but not eliminated. These legitimate transactions utilize an important tax planning tool. Payment of tax occurs:

  1. upon sale of the replacement asset;
  2. incrementally, through increased income tax due to foregone depreciation; or
  3. by inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate more than double the capital gains tax rate.

Having nothing at all to do with footwear, “Boot” is a term that refers to the items of personal property and/or cash that are necessary to even out an exchange. Boot is property that is received in an exchange but is not “like-kind” as to other property acquired in an exchange transaction. Boot is defined as the “fair market value” of the non-qualified property received in an exchange.

The use of a Qualified Intermediary is essential to completing a successful IRC §1031 tax deferred exchange. Investment Property Exchange Services, Inc. (IPX1031), as a professional Qualified Intermediary, performs several vital functions in an exchange and operates under the “safe harbor” set out in Treas. Reg. 1.1031(k)-1(g)(4). Although the process of completing an exchange is relatively simple, the rules are complicated and filled with potential pitfalls.

When selecting a Qualified Intermediary, the Exchanger must feel confident that their Qualified Intermediary is a professional company with the competence and commitment to provide high quality service and security for exchange funds.

A “reverse” exchange occurs when the taxpayer acquires the replacement property before transferring the relinquished property. A “pure” reverse exchange, where the taxpayer owns both the relinquished and replacement properties at the same time, is not permitted.

For an exchange to satisfy IRC §1031, the taxpayer that will hold the title to the Replacement Property must be the same taxpayer that held title to the Relinquished Property. However, business considerations, liability issues, and lender requirements may make it difficult for the Exchanger to keep the same vesting on the Replacement Property. Exchangers must anticipate these vesting issues as part of their advanced planning for the exchange

Since 1984, IRC §1031 has specifically excluded exchanges of partnership interests from non-recognition treatment. Thus, §1031 does not apply to an exchange of interests in a partnership regardless of whether the interests exchanged are general or limited partnership interests or are interests in the same partnership or in different partnerships, even if both partnerships own the same kind of real property.

Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality. Real properties generally are of like-kind, regardless of whether they’re improved or unimproved. For example, an apartment building would generally be like-kind to another apartment building.

The tax deferred exchange, as defined in §1031 of the Internal Revenue Code, offers taxpayers one of the last great opportunities to build wealth and save taxes. By completing an exchange, the Taxpayer (Exchanger) can dispose of investment or business-use assets, acquire Replacement Property and defer the tax that would ordinarily be due upon the sale.

A successful IRC §1031 exchange transaction requires planning, expertise and support. Read more here…

While both 721 and 1031 exchanges provide a way to defer capital gains taxes, a 1031 exchange involves exchanging one property for another of “like-kind.” In contrast, a 721 exchange involves transferring property into an operating partnership in return for its shares or units.

Read our article on the following page.

721 FAQs

A 721 exchange, often called an “UPREIT” (Umbrella Partnership Real Estate Investment Trust), allows investors to transfer real estate into an operating partnership in exchange for shares or units, without triggering a taxable event.

While both 721 and 1031 exchanges provide a way to defer capital gains taxes, a 1031 exchange involves exchanging one property for another of “like-kind.” In contrast, a 721 exchange involves transferring property into an operating partnership in return for its shares or units.

Read our article on the following page.

A 721 exchange can be beneficial when an investor wants to diversify their real estate holdings, receive a steady income stream, or transition to a more passive investment role. It also offers a way to become a part of a larger real estate portfolio.

The primary criterion is that the property must be transferred to a REIT or its operating partnership. The specifics may vary based on the REIT’s strategy and investment focus.

The primary advantage of a 721 exchange is the deferral of capital gains tax when property is transferred to a REIT in exchange for its units or shares. However, taxes will be due upon the eventual sale of those shares or units.

Yes, many REITs provide an option for investors to convert their operating partnership units into REIT shares, which can then be publicly traded.

One key limitation is that not all REITs will accept properties in exchange for operating partnership units. Additionally, the exchange can be more complex than a standard 1031 exchange and might involve more intricate negotiations and legal documentation.

Unlike the 1031 exchange, which has specific identification and acquisition timelines, the 721 exchange doesn’t have set time constraints. However, the specifics of the deal and the agreement with the REIT can introduce certain deadlines.

In such scenarios, the investor could receive their proportionate share of the assets or the proceeds from the liquidation. This event might trigger a taxable event, and the capital gains tax would be applicable.

Yes, this strategy, often referred to as a “1031 into 721” exchange, allows investors to first exchange real property for like-kind property (1031 exchange) and then later transfer it into a REIT using a 721 exchange. This method can offer additional flexibility and tax deferral benefits for the investor.