Question: What is a Section 1031 Exchange?

Answer: Section 1031 of the Internal Revenue Code provides an alternative strategy for deferring capital gains tax that may arise from the sale of a property. By exchanging a relinquished property for “like-kind” real estate, property owners may defer federal taxes and use all proceeds from the sale for the purchase of replacement property. To determine if a transaction will qualify under Section 1031 depends on the following factors.

  • The nature and use of the relinquished property and the method of its disposition.
  • The use of a qualified intermediary and a qualified exchange escrow and the amount of time between the sale of the relinquished property and the identification and acquisition of the replacement property.

Question: What is like-kind property?

Answer: Any real estate held for productive use in a trade or business or for investment purposes is considered like-kind.

Examples include:

  • Multifamily apartments
  • Self-storage facilities
  • Healthcare facilities
  • Student housing
  • Office buildings
  • Retail centers
  • Industrial warehouses
  • Vacant land
  • Farmland or ranches
  • A tenant-in-common ownership interest in an investment property.
    Tenant-in-common (TIC) ownership is ownership of commercial real estate that has been split into fractional shares. Each owner owns an undivided fee interest in the property equal to his proportionate share of the real estate.
  • A beneficial interest in a Delaware statutory trust (DST)
  • Vacation homes or rental properties may qualify

Question: What is a Delaware statutory trust (DST)?

Answer:A DST is a business trust created under Delaware law. DSTs can be used in a wide variety of business settings and have become popular pass-through entities to hold commercial real estate assets for investors. In accordance with the Internal Revenue Service’s Revenue Ruling 2004-86, a beneficial interest in a DST that holds a replacement property may be considered like-kind replacement property in a Section 1031 Exchange. A DST may own one or more properties.

The rights and obligations of investors in a DST will be governed by the DST’s trust agreement. Typically, investors have limited voting rights over the operation and ownership of any properties owned by the DST. In addition, the trustees of the DST may be entitled to certain fees and reimbursements, as set forth in the applicable trust agreement.

Upon the sale of a property in a DST, the investor will have the option to pay any capital gains tax or defer any capital gains tax by participating in a 1031 Exchange.

Question: How do vacation and second homes qualify for Section 1031 Exchanges?

Answer: Vacation or second homes held by the exchanger primarily for personal use do not qualify for tax deferred exchange treatment under Section 1031. The safe harbor for a vacation or second home to qualify as relinquished property in a Section 1031 Exchange requires the exchanger to have owned the property for twenty-four months immediately before the exchange, and within each of those two twelve-month periods the exchanger must have:

  • Rented the property at fair market rental for fourteen or more days, and
  • Restricted personal use to the greater of fourteen days or 10% of the number of days that it was rented at fair market rental within that twelve-month period

For these purposes, “personal use” includes use by the exchanger’s friends and family members that do not pay fair market value rent.

Question: What are the benefits of a Section 1031 Exchange?

Answer:In addition to deferring capital gains tax, benefits to participating in a Section 1031 Exchange include:

  • Passive real estate ownership and management
  • Exchange a non-cash flow producing property for a cash flow producing property
  • Diversify into a portfolio of properties
  • Diversify an existing portfolio by geography and property type
  • Obtain ownership in higher-grade commercial properties
  • Facilitate estate planning

Question: How can my heirs continue to benefit from this type of investment strategy?

Answer:By investing in a DST, heirs may receive any distributions paid from the investments. Upon the sale of the property owned by the DST, each heir can choose what to do with their inherited portion. It is possible that one heir continues to exchange the investment, while another can sell and receive cash proceeds. Should the DST investor pass away, under the current tax laws, the heirs would get a “step-up” in tax basis bringing the investment up to fair market value, thereby potentially deferring capital gains taxes on the original and subsequent properties.

Question: What are some key guidelines for a Section 1031 Exchange?

Answer:1031 Exchange investors:

  • Are required to reinvest all proceeds earned from the sale of a property
  • Need to reinvest in like-kind real assets
  • Must comply with debt and equity replacement requirements
  • Engage a Qualified Intermediary (QI) to facilitate the exchange
  • Have 45 calendar days to identify a replacement property
  • Complete reinvestment in replacement property within 180 days from the sale date of the original property

This is a summary of some of the key guidelines for a transaction under Section 1031, but this is not an exhaustive list. The costs associated with a Section 1031 Exchange may impact the returns and may outweigh the tax benefits of the transaction. Each prospective investor must consult his or her own tax advisor regarding the qualification of a particular transaction under Section 1031.

Question: What is a Qualified Intermediary (QI)?

Answer:A QI is a company that is in the full-time business of facilitating Section 1031 tax-deferred exchanges. The QI enters into a written agreement with the taxpayer (exchanger) and is responsible for the transfer of a relinquished property to the buyer. The QI holds the proceeds from the sale of the relinquished property in a trust or escrow account to ensure the taxpayer never has actual or constructive receipt of sale proceeds. Finally, the QI transfers the replacement property to the taxpayer pursuant to the exchange agreement.

A QI may also be known as an Accommodator, Facilitator or Qualified Escrow Holder. Certain persons, including those who have acted as the exchanger’s employee, accountant, attorney, investment banker or broker or real estate broker within the two year period preceding the sale of the relinquished property, will be specifically disqualified from acting as a QI.

Question: Can I keep some money for personal use?

Answer:Yes, taxpayers may take cash proceeds from the sale before the funds are sent to the QI. This is known as “boot.” The taxpayer will pay capital gains tax on the boot received but not on the proceeds that were reinvested/exchanged. The calculation of tax due is complicated and involves basis, depreciation, and an analysis of state and federal taxes. Prospective investors should consult their tax advisor before deciding to retain funds from a sale.


About "Top tips to consider when selling the farm"

Selling your family farm is big decision. Many farms have been part of a family's history for generations and letting go of the property has sentimental and financial implications. We compiled a checklist of our top tips to help farmers and ranchers, like you, navigate this new territory. It may be possible to defer taxes by reinvesting the proceeds in a like-kind investment.

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Real Estate

Real estate investments have the potential to help generate retirement income and build long-term wealth to pass on to heirs.

Tax Deferral

A Section 1031 exchange can help you transition to another real estate investment while deferring capital gains taxes.

Passive Possibilities

If you’re ready for a less stressful form of real estate ownership, consider a passive strategy.

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