1031 EXCHANGES

A 1031 Exchange refers to Section 1031 of the Internal Revenue Code, which allows an investor to exchange like-kind properties (i.e., real estate held as an investment or for productive use in a trade or business) and defer taxation of capital gains and the recapture of depreciation deductions, if certain procedures are followed. In 2002, the IRS issued guidelines which established the conditions under which it would consider a Private Letter Ruling that would qualify a TIC for 1031 Exchange purposes. Since that time, TICs have become a popular choice among investors seeking 1031 Exchange replacement properties. A 1031 Exchange into a tenant-in-common property may allow an investor to sell highly-appreciated property without current taxation, allowing them to preserve wealth by locking in gains produced in one geographic location or one property type, and freeing money for investment in another property located elsewhere.

1031 Exchange Rules

The typical 1031 Exchange involves selling one investment property (the relinquished property, or the “down-leg”) and buying another investment property (the replacement property, or the “up-leg”). Once an investor has sold the original property, they have 45 days to identify up to 3 replacement properties (special rules apply if more than 3 replacement properties are identified).

Once identified, and after the 45-day period has expired, the investor may not identify any additional properties. The investor will be required to close on one or more of the identified properties only. The investor has a total of 180 days from the sale of the property (or until the due date of taxes for the tax year in which the property was sold, whichever comes first) to actually close on the identified replacement properties. In order to avoid all taxes in the exchange, an exchanger must be sure to buy a replacement property with the same or greater market value as the relinquished property, take on the same or greater debt as before the exchange, and must use all of his or her equity in the exchange. Failure to do so can result in the creation of “boot”, which could result in a taxable event.

The Role of the Qualified Intermediary

1031 Exchange Considerations

Given the need to locate and trade into replacement properties with the same or greater value, debt and equity ratios as the relinquished property, as well as the need to conduct significant due diligence on the replacement properties under consideration, the challenges for the single-owner of investment property are clear: how to accomplish all this within the IRS’s restrictive time frames? Further, if one is considering purchasing a replacement property in the same geographic area as the property being relinquished, one runs the risk of trading into yet another highly-appreciated property with lower-than-average current income yields. And, of course, if an investor is looking to relieve themselves of some of the management responsibilities currently burdening them with their relinquished property, a 1031 Exchange will not, in-and-of itself, solve this investor’s dilemma. Choosing a Tenant-in-Common investment as a replacement property, however, could potentially alleviate many of these challenges.