§1031 Basics and Beyond

For over 100 years Section §1031 of the IRS Code has allowed taxpayers to supercharge their wealth building through real estate investment. And, for just as long, most taxpayers have found §1031 Like-Kind Exchanges to be somewhat (or very) confusing! Actually, it’s easy(ish)—so let’s dive in!

Step 1: Is the juice worth the squeeze?

Many potential exchangers misunderstand the tax implications of their sale and mistakenly believe they must perform a §1031 exchange. However, this isn't always necessary. In some cases, the benefits of tax deferral may not justify the costs and reduced liquidity associated with an exchange. Therefore, it's crucial for taxpayers to calculate their tax liability before deciding to pursue a §1031 exchange.

Here's how to calculate the tax on the sale of an investment property:

1.   Calculate the Tax Basis:

o   Start with the purchase price of the property.

o   Add transactional costs of purchase.

o   Include any improvements made to the property.

o   Subtract the total depreciation claimed over the years.

Tax Basis = Purchase Price + Transactional Costs of Purchase + Improvements – Depreciation

2.  Calculate the Capital Gain:

o   Begin with the selling price of the property.

o   Subtract transactional costs of the sale.

o   Deduct the tax basis (calculated above)

Capital Gain = Selling Price - Transactional Costs of Sale - Tax Basis

When selling a property, there are typically three types of taxes that may apply: capital gains tax, depreciation recapture, and the Medicare surtax.‍

Capital Gains Tax: This is taxed at the federal level, with a rate of 20% for married couples filing jointly with taxable income over $583,750 in 2024. State taxes also apply, varying by location (e.g., Minnesota at 9.85%, North Carolina at4.5%, and South Carolina at 6.4%).

DepreciationRecapture:This is taxed at the taxpayer’s ordinary income rate, up to a maximum of 25%.

Medicare Surtax: An additional 3.8% surtax applies to the gain amount

Step 2:  Rules, Restrictions and Requirements

IRC §1031 is synonymous range of rules, restrictions, and requirements and there are many hoops taxpayers must jump through to properly execute an exchange. One of the initial steps in executing a §1031 exchange is determining whether the property being sold—known as the relinquished property—qualifies for the exchange. The IRS code requires that the relinquished property must be held for investment or used in a business or trade, which means primary residences and second homes do not qualify.

A commonly overlooked aspect is that business owners can defer taxes on the value of real property included in the sale of a closely held business, provided it is not the stock but the asset sale. Mirroring the “use requirement” on the acquisition side, the replacement property must also be intended for investment or use in a business or trade. The IRS refers to properties meeting this requirement as “like-kind.”

Another important requirement under IRC §1031 pertains to timing and deadlines. Within 45 days from the sale of their relinquished property, exchangers must identify in writing, up to three potential replacement properties to their Qualified Intermediary. Concurrently, they have 180 days from the sale to finalize the purchase of one, two, or all three of the identified properties, or to close on none of them. This timing requirement is commonly known as the "45/180 day rule."

One of the more confusing rules that often gets misinterpreted is the replacement value requirement for tax deferral. To fully defer taxes on the sale of a relinquished property, the replacement property or properties must be of equal or greater value than the property sold. For instance, if you sell a property and, after transaction costs, receive a net amount of $1,000,000, but only$750,000 in cash after settling the mortgage, you are required to acquire replacement property worth at least $1,000,000. The $750,000 in cash proceeds will be held by the Qualified Intermediary. To cover the remaining $250,000, you can either take out a new mortgage or use additional personal funds. If you don't purchase replacement property worth at least $1,000,000, you'll face taxes on the difference, known as "boot," up to the basis of the original property. However, Section 1031 is not an all or nothing proposition and allows for partial exchanges. This means you can choose to replace only a portion of the relinquished property's value and take some cash from the sale. Just keep in mind that any cash you take out will be taxable up to the property's tax basis.

Lastly, the IRS mandates that the individual or entity acquiring the replacement properties must be the same taxpayer or tax entity that held title to the relinquished property. For example, if Jim Smith sells a property, it must be Jim Smith, oran entity in which Jim Smith is the sole member or taxpayer, who purchases the replacement property. Jim Smith cannot sell the property and have his brother, Bob Smith, purchase the replacement property to meet the "Same Taxpayer Requirement" under IRC §1031.

Investment properties or properties held within a business are often owned within a legal entity known as a Partnership. While this structure is very effective and efficient for joint property ownership and management, it complicates the process of selling a property when each partner wants to take their interest and pursue a §1031 exchange individually. For a Partnership to successfully execute a §1031 exchange, it must sell the property under the Partnership's name and buy the replacement property or properties with the identicalPartnership structure, as dictated by the same taxpayer rule. This means the taxpayer entity that sold the property must be the same. However, there are strategies that allow a Partnership to complete an exchange while enabling each partner to handle their proportional share of the proceeds independently. For more information on these strategies, please refer to the Lamplighter Blog titled: Going Separate Ways: Preserving Partners’ Individual Interests through a §1031 Exchange.

Step 3:  What to doin preparing for your exchange

So... now that you’ve determined the juice is worth the squeeze and that the benefits of a§1031 Exchange outweigh the costs and effort, and you understand the key rules and requirements to successfully complete an exchange, you’re ready to start the process. Here are a few essential steps to take before selling your property:

1) §1031 Language in Your Purchase Agreement: Make sure that your Realtor or Attorney includes specific language in yourPurchase Agreement indicating your intention to conduct a §1031 Exchange. This is an IRS requirement, so it’s crucial to include this. If the language is not already in the agreement, you will need to have the buyer sign an addendum to add it.

2) Engage a Qualified Intermediary: To complete a §1031 exchange, the IRS requires you to hire an independent third-party escrow agent, known as a Qualified Intermediary (QI), to hold the proceeds after closing. This ensures the funds are securely managed until you decide on the replacement property or properties. Individuals or entities directly involved in your transaction, such as your attorney, CPA, or Realtor, cannot serve as your QI.

Your Qualified Intermediary (QI), also referred to as an Exchange Accommodator, is a vital participant in your §1031 exchange, and not all QIs are created equal. While Lamplighter §1031 Advisors does not provide QI services, we can assist you in selecting the right QI for your unique exchange. A good starting point is to choose a QI who is a member of the Federation of Exchange Accommodators (www.1031.org/find-a-qi-company#/).

Engaging aQualified Intermediary (QI) initiates the process of preparing your closing to meet the requirements of a §1031 exchange. A good QI will make the process easy to understand, working closely with your realtor, attorney, and title company to ensure everyone is on the same page and that your tax deferral benefits are protected. Effective communication and transparency are crucial, so make sure you understand how your QI will keep you and your team in the loop through out the process. It is also important to ensure that the QI is bonded, insured, and maintains your §1031 funds in a separate, segregated account from other clients' funds.

§1031 Like-Kind Exchanges are a powerful tool for preserving and building wealth. At Lamplighter §1031 Advisors, we are dedicated to educating and guiding you through this often complex and sometimes confusing process. Our goal is to ensure not only a successful exchange but also a well-planned strategy that allows you to accomplish your tax, financial, and estate planning goals. We hope this blog has been helpful in providing a clear understanding of the“basics and beyond” of a §1031 Exchange.

For more information or to speak with one of our Team Members, email: info@lamplighter1031.com or call 952-758-1031.

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