Last updated on June 23rd, 2021 at 02:53 pm
Actual receipt | Boot | Capital gain | Constructive receipt | Delaware statutory trust (DST) | Delayed 1031 exchange | Depreciation recapture | Direct deeding | DST interests | DST sponsor | Escrow agent | Exchange accommodation titleholder (EAT) | Exchange agreement | Exchange period | Exchanger | Form 8824 | Grant deed | Identification period | Identification requirements | Improvement 1031 exchange | Intangible property | Interest income | Internal revenue code (IRC) | Internal revenue service (IRS) | Like-kind exchange | Like-kind property | Mirror image | NNN lease | Opportunity zone | Opportunity zone fund | Parking arrangement | Partial 1031 exchange | Personal property | Promissory note | Qualified exchange accommodation agreement | Qualified indicia of ownership | Qualified intermediary | Qualified use | Real property | Related parties transaction | Relinquished property | Replacement property | Reverse 1031 exchange | Safe harbor | Section 1031 | Section 1033 | Signatory trustee | Special purpose entity (SPE) | Starker exchange | Tax deferral | Taxpayer | Tenant in common (TIC) | Trust | Umbrella partnership real estate investment trust (UPREIT)
What is a 1031 exchange?
Section 1031 of the U.S. tax code defines a 1031 exchange as a like-kind exchange of one investment property for another in which capital gains tax liability is deferred. Like-kind properties, according to the IRS, are properties of the same nature, character, or class.
Because capital gains taxes can take a huge chunk of profits, a 1031 exchange can be an extremely valuable tax strategy for real estate investors. And 1031 exchanges can be used repeatedly — meaning you can exchange many like-kind properties, deferring capital gains each time. You could potentially avoid paying any capital gains tax until you liquidate your holdings.
1031 exchanges come with many rules, governing everything from the amount of time you have to complete your property swap, to the kinds of properties that are eligible for 1031 exchanges, to the type of third party intermediaries you’re allowed to use to facilitate the trade.
That means it’s vital to understand what you’re getting into, and to make sure you stay within the rules. If you’re thinking about a 1031 exchange, consult with a 1031 exchange expert to find out how to start building a tax-deferred real estate empire.
Definitions of 1031 exchange terms
Like the finer points of the U.S. tax code, 1031 exchanges involve a lot of technical jargon. Below is a comprehensive guide to the terms and definitions you’ll need to understand during a 1031 exchange.
Actual receipt means you’ve received the money from the sale of your initial property, also known as the relinquished property.
You want to avoid this at all costs, as it will render your 1031 exchange invalid. Only your qualified intermediary can handle the proceeds from your initial sale.
Boot is any non-like-kind property that you receive as part of your 1031 exchange.
This can include cash, stocks, bonds, debt relief, or personal property (as opposed to business/investment property). Boot doesn’t invalidate a 1031 exchange — but it is taxable.
There are two kinds of boot:
Cash boot is the “net cash received” at the end of a 1031 exchange. It comes into play when the value of the new property, also known as the replacement property, is less than the value of the old property, aka the relinquished property.
Mortgage boot occurs when the new property’s mortgage is less than what’s left on the old property’s mortgage. The difference is taxed at your personal capital gains rate.
Capital gain is the profit you make from the sale of your investment. It’s equal to the difference between the sale price and the initial purchase price.
You have control over or access to the proceeds from your sale, even if you don’t have physical possession of it.
Here’s an example: Your lawyer holds the funds from your initial sale. Even though you personally don’t have the money in your possession, also known as actual receipt, this counts as constructive receipt since your lawyer acts as your agent, and follows your orders.
Delaware statutory trust (DST)
A kind of trust created under Delaware state law. Investors can exchange their property for fractional interests in a DST— and vice versa.
This means that you can sell your property and use a 1031 exchange to buy into a DST. If multiple investors are in a DST, each can sell their portion as part of a 1031 exchange.
This isn’t the case for multiple investors who share in a property through an LLC or partnership.
» READ MORE: The Ultimate Guide to 1031 Exchange DST
Delayed 1031 exchange
Another name for a typical 1031 exchange.
If you’ve claimed depreciation deductions on your tax return while you’ve owned the property you’re selling, an equivalent amount of your gains will be taxed at the depreciation recapture rate.
For example, if you’ve taken $250,000 of depreciation deductions on a property you bought for $1 million, and then sell it for $2 million, the first $250,000 of gains on the sale will be taxed at the depreciation recapture rate (which is usually similar to the income tax rate).
The rest of your gains will be taxed at the capital gains rate.
Need more details? Contact a 1031 exchange expert today, and we’ll walk you through the process, step-by-step.
In a typical 1031 exchange, it’s standard practice for the relinquished property to be conveyed (or direct deeded) from the exchanger to the buyer once the 1031 exchange has been executed.
Your ownership share of a Delaware Statutory Trust (DST).
The person or company that creates the Delaware Statutory Trust (DST). The DST sponsor also oversees many phases of the DST, including sourcing properties, managing financing and structure, and putting the final package together.
A neutral third party that holds funds during the transaction, and then releases them once the agreement’s been executed.
Exchange accommodation titleholder (EAT)
In a reverse 1031 exchange, the EAT holds onto the title to the new property until the old property is sold. In an improvement 1031 exchange, the EAT holds the title to the new property, and gives it to the exchanger after improvements are made.
This agreement lays out the terms and conditions of the 1031 exchange.
1031 exchanges must be completed within a period of 180 days or they’re invalid. The exchange period can also end when the taxes are due, if that comes before 180 days are up.
To complete a 1031 exchange, IRS Form 8824 must be filled out and submitted to the IRS.
A document that officially transfers a property from one person to another.
The 45-day period of time, starting from the close date of the old property, during which you must identify the next property you’re exchanging for, known as the replacement property.
You’re allowed to identify up to three potential new properties, also known as the replacement properties, and they have to be identified within 45 days of the close of the old property.
You don’t need to be under contract or in escrow on the replacement property. You only need to identify the property to your qualified intermediary.
Improvement 1031 exchange
Also called a build to suit 1031 exchange, or construction 1031 exchange, this type of 1031 exchange allows the investor to use the sale proceeds from the first property, known as the relinquished property, on construction or improvement on the new property, known as the replacement property. This can mean anything from minor renovations to new, ground-up construction.
Keep in mind, all work must be completed within the 180-day exchange period.
Assets that don’t have any physical substance. For example, patents, licenses, copyrights, software, or cryptocurrency.
As of January 1, 2018, intangible property is ineligible for a 1031 exchange.
While your qualified intermediary holds the funds from your initial sale, those funds typically accrue interest. This money is usually split according to a prearranged agreement with the qualified intermediary.
Internal revenue code (IRC)
U.S. tax law, enforced by the Internal Revenue Service (IRS).
Internal revenue service (IRS)
U.S. government agency responsible for collecting taxes and enforcing tax law.
A tax-deferred exchange in which one asset is exchanged for a similar asset of the same nature, character, or class.
When two properties belong to the same category or type, they’re called like-kind.
Like-kind property can have a broad interpretation. For example, vacant land, office buildings, and residential properties are all considered like-kind.
Also called a triple net lease, this lease arrangement requires the tenant to pay all the property expenses, including taxes, maintenance, and insurance, in addition to rent and utilities.
NNN leases are popular with investors who are looking to exchange multiple properties for one larger one — but want to avoid the complications and expense of property management.
An opportunity zone allows investors to reinvest unrealized capital gains into real estate in lower-income areas.
If investors hold their investment for at least 10 years, they could pay zero capital gains taxes on that investment.
Opportunity zone fund
The investment vehicle required for investing in an opportunity zone.
Currently, individuals can self certify on their tax return that they’re investing as an opportunity zone fund. No approval is required.
An arrangement in which the investor “parks” the title of their new property with an exchange accommodation titleholder while the 1031 exchange is being completed.
Partial 1031 exchange
Any possession that’s movable and owned by an individual. Land and buildings are not considered personal property.
As of 2017, personal property isn’t eligible for a 1031 exchange.
A written promise by one party to pay another party a sum of money.
The note typically includes the terms of the agreement — due dates, interest rates, etc.
Qualified exchange accommodation agreement
An arrangement in which a third party (the accommodation party) temporarily holds onto an investor’s property to enable a reverse 1031 exchange.
Qualified indicia of ownership
The required proof, usually legal title, that a third party is holding the property for an investor executing a reverse 1031 exchange.
Basically, the document proves the third party legally owns the property during their phase of the reverse 1031 exchange.
Qualified intermediary (QI)
A third party that enables the 1031 exchange.
This middleman receives the relinquished property from the investor, and sells it to the buyer, while also buying the replacement property and transferring it to the investor.
A qualified intermediary, often abbreviated to QI, helps satisfy the legal requirements of a 1031 exchange, but may not guide you through the process — especially not during the crucial early phases.
Contact a 1031 exchange expert now, and we’ll help you understand exactly what a 1031 exchange can — and can’t — do for you.
Only properties used for certain purposes (“qualified uses”) are eligible to be included in a 1031 exchange. This typically means properties that are held for investment purposes, or used in business.
Land, plus any structures on it.
Related parties transaction
A transaction between two parties that have a prior relationship.
Related parties transactions are legal in a 1031 exchange, but do require disclosure.
The old, or initial, property being sold.
The new property being purchased.
Reverse 1031 exchange
A 1031 exchange in which the new replacement property is bought before the old property, also known as the relinquished property, is sold.
» READ MORE: What Is a Reverse 1031 Exchange? (We Diagram It)
The four methods, detailed in U.S. tax law, that enable a smooth and legal 1031 exchange.
The four safe harbors are:
- Qualified intermediaries
- Interest and growth factors
- Qualified escrow accounts or qualified trusts
- Security or guaranty arrangements
These safe harbors can be used separately or in combination, as long as the required conditions are met for each harbor.
The section of U.S. tax law that defines the 1031 exchange.
The section of U.S. tax law that expanded tax-deferred exchanges to include forced loss of property. For example, property loss due to natural disaster or eminent domain.
One of the managers of a Delaware Statutory Trust (DST). The signatory trustee shares responsibilities with the independent trustee and the Delaware trustee.
Special purpose entity (SPE)
A type of legal entity that insulates the participants from bankruptcy.
A Delaware Statutory Trust is a kind of SPE.
Starker exchange is another term for a typical 1031 exchange.
The term Starker exchange comes from the court case “Starker vs. United States,” which helped define the modern 1031 exchange.
Delaying tax liability until a future date.
The person or entity that initiates a 1031 exchange.
Tenant in common (TIC)
A type of ownership arrangement in which multiple owners own and control different shares of the property.
A legal entity that holds a property and provides that property with certain legal protections.
Umbrella Partnership Real Estate Investment Trust (UPREIT)
An Umbrella Partnership Real Estate Investment Trust is an exchange in which an investor trades a property for shares of a real estate investment trust (REIT) that equal the value of that property.
The UPREIT is defined in section 721 of U.S. tax law.