The 1031 Exchange - What You Need to Know

Whether you are a new investor in real estate, or an experienced investor who has bought and sold many properties, you have likely heard of a 1031 Exchange. Perhaps you have never had a reason to utilize this tax saving method of buying and selling investment real estate, but are now in a position where you need to use a 1031 exchange because you are selling your investment real estate. No matter where you stand in your knowledge of the 1031 tax exchange...we are going to explain the basics, and a few of the nuances you need to be aware of. What is the one thing you do not want to do when considering a 1031 tax exchange? Anything wrong at all. You risk a heavy tax consequence if you do.

Simply put, a 1031 tax exchange is a way to preserve capital and utilize that capital to purchase another like-kind investment property (or properties). Not so simply put, the term "1031 Exchange" actually refers to Section 1031 of the Internal Revenue Code (IRC). This section of the IRS tax code allows for an exemption of capital gains taxes whenever you sell an investment property or a business related property. The caveat? You have to reinvest your gains, or proceeds, back into a similar property through what is called a "like-kind" exchange. So what the heck is a "like-kind" exchange? Well, pretty much what it sounds can exchange your investment property, or property used in your business/trade, for another investment property or property used in your business/trade. Essentially, this code was developed because it does not make sense to tax a person/entity on gains from the sale of an investment property where they never receive any proceeds from the sale because they are reinvesting in another investment/business property. It has also helped ensure the security and longevity of the commercial/investment real estate market.

On its surface, this seems simple. However, there are a multitude of requirements you must meet in order to ensure not only a smooth transaction, but also so you do not have a major tax liability. When I say major tax liability...I mean it. The best way to illustrate this is through an example, so let's use an example of a recent transaction by Ms. Investor.

Ms. Investor purchased a 24-unit garden-style apartment community in Florida about 15 years ago. As with property nearly anywhere, but particularly in Florida, it has increased substantially in value to the tune of about three-times what Ms. Investor paid for it. Ms. Investor has a great opportunity to buy another investment property in a growing area and has decided to sell her current investment and use the proceeds to purchase the new property. Understanding that there could be tax consequences, she calls her accountant to determine what the tax consequences may be. Her accountant takes a look at the tax considerations and determines the Net Adjusted Basis of the property. What is that?

Net Adjusted Basis

To determine the net adjusted basis, you take the original purchase price, add capital improvements, and then deduct the depreciation that was taken over the ownership of the property.

Through evaluation, Ms. Investor's accountant finds that her net adjusted basis has been reduced quite a bit due to the depreciation that has been recognized over the years. Here's what it looks like:

Original Purchase Price $1,250,000

Capital Improvements $25,000

Depreciation Taken During Holding Period ($750,000)

Net Adjusted Basis $525,000

To come to the potential tax consequence, Ms. Investor's accountant has to determine the potential capital gains on the property if sold. Once he determines the capital gains, he advises here that she faces a significant tax consequence if she sells the property without doing a 1031 exchange. How did he determine capital gains? He takes the current day sales price minus the net adjusted basis, then deducts closing costs (sale price - NAB - closing costs).

In this case, it looks like this:

Sales Price if Sold Today $3,250,000

Net Adjusted Basis (from above) ($525,000)

Closing Costs Related to the Sale ($50,000)

Capital Gain $2,675,000

The accountant tells Ms. Investor that this $1,925,000 in capital gains consists of:

* $750,000 in depreciation, which is typically taxed at a 25% tax rate

* In this case, Ms. Investor is in the highest tax bracket, so the remaining $2,175,000 will be taxed at a long-term capital gain rate of 23.8% (this includes the 20% in long term capital gains, and the 3.8% for the Medicare surtax on net investment income)

Fortunately, Ms. investor is a Florida resident, so there is no state income tax. Had she been in California, she would pay an added state tax at 13.3% in addition to the 23.8%, for a total tax liability of over 37%! Good thing she is in Florida! Here is what it looks like:

Capital Gain $2,925,000

Depreciation Recapture ($750,000)

Net Capital Gain $1,925,000

Tax on Depreciation Recapture (25%) $187,500

Federal Capital Gains Tax (20% Federal Rate) $285,000

Medicare Surtax (3.8%) $73,150

Total Tax Liability $545,650

(Imagine if you live in California...add another $256,025 in tax consequence!

Now let's say that Ms. Investor has a loan balance on the property of $600,000. The net proceeds once the loan is paid off and closing costs are paid will be $2,600,000 (Sale price @ $3,250,000 - closing costs @ $50,000 - the loan balance @ $600,000). If Ms. Investor decides to cash out, she will only receive about 79% of the sale proceeds once federal taxes are paid ($2,600,000 - $545,650 = $2,054,350 / 2,600,000).

Ms. Investor's commercial real estate broker recommends that she consider at 1031 tax-deferred exchange in order to defer that tax liability and preserve some of her wealth. Let's take a look at how Ms. Investor's purchasing power changes if she uses the 1031 tax-deferred exchange over paying the capital gains vs. reinvesting those funds after taxes. For the purposes of this example, we will assume a 70% loan-to value (LTV) on a new acquisition.

Without Using the 1031 Tax-Deferred Exchange:

After tax proceeds from the sale = $2,054,350

Max. Purchase Price for a New Property (70% LTV) = $6,847,833

Using a 1031 Tax Deferred Exchange:

Sale Proceeds = $2,600,000

Max. Purchase Price for a New Property (70% LTV) = $8,666,667

Advantage of Using 1031 Tax Deferred Exchange for Purchasing Power =


Once Ms. Investor sees these numbers, she makes the wise decision to use a 1031 exchange with her sale proceeds. Ms. investor'As broker places her property on the market and, 15 days later, her property goes under contract. 30 days after that, her property is sold for $3,250,000.

The proceeds from the sale are immediately transferred to her Qualified Intermediary (QI), where the sale proceeds will be held until Ms. Investor finds a replacement property. Having a Qualified Intermediary is paramount in the 1031 exchange process. At no time can Ms. Investor have direct access to the sale proceeds. If this happens, Ms. Investor will have violated the 1031 exchange requirements and a taxable consequence is triggered. With that said, let's talk about what steps you can take to ensure that your 1031 exchange goes off without a hitch.

Identify the Replacement Property(ies)

The hard and fast rules on this one are that you have 45 days to identify your replacement property(ies) beginning on the closing date of your relinquished property. You also have 180 days from this same date to complete your acquisition of the relinquished property(ies). As an example, let's assume you close on your relinquished property on March 15th, the first day of your 45 day identification period and 180 day closing requirement is March 15th (day one). To be clear, the identification period and the closing period run concurrently. It is very important to know these dates and stick to this timeline or you will trigger a taxable event.  

A Few Rules 

Three Property Rule - this is fairly straight forward and is a rule utilized by most taxpayers doing a 1031 exchange. It says that you, the taxpayer, may identify up to three properties for your exchange regardless of the fair market value of the properties. We all know that not every deal closes and because you have only 45 days to identify, you can not throw all of your eggs in one basket. If one falls through, at least you have two others in the pipeline that have met the 45 day identification requirement.

200% Rule - Here is what the IRS says:

 “Any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer.”

In other an identify as many properties as you like, and close on any number of them you wish to, as long as the total market value of all of the properties does not exceed two-times (200%) the market value of the property you relinquished. There is some debate on how market value should be determined when identifying, but a good rule of thumb that should keep you out of trouble is to use the listing price.

95% Rule - Let's, again, first take a look at the exact wording from the IRS, then we will discuss this in a way that makes more sense:

“Any replacement property identified before the end of the identification period and received before the end of the exchange period, but only if the taxpayer receives before the end of the exchange period identified replacement property the fair market value of which is at least 95 percent of the aggregate fair market value of all identified replacement properties."

Although this is a rule, many taxpayers find this a tough one to adhere to and do not utilize it. However, it is important to understand. Let's say you have over-identified for the first two rules. You may still have a valid exchange, as long as you receive 95% in value of what you identified. As an example, let's say you identified four (or more) properties and that value has exceeded the 200% rule. You are not in compliance with the Three-Property Rule or the 200% Rule at this point. However, as long as you receive 95% of what was "over" identified, the exchange will still be deemed proper. In reality, this is a tough rule for you to truly rely on. Good to know though!

The Incidental Property Rule - What does it say?

“Solely for purposes of applying this paragraph (c), property that is incidental to a larger item of property is not treated as property that is separate from the larger item of property. Property is incidental to a larger item of property if - (A) In standard commercial transactions, the property is typically transferred together with the larger item of property, and (B) The aggregate fair market value of all of the incidental property does not exceed 15 percent of the aggregate fair market value of the larger item of property.”

So, what does it really say? Here is where we start to get into the "boot" subject. We will talk about "boot" shortly, but this is where a form of "boot" can come from. Sometimes, in a commercial transaction, there is "incidental" property that passes to the buyer in the sale. As long as this "incidental" property does not exceed 15% of the value of the real property, this incidental property does not have to be separately identified. If it were, this would be "boot" and subject to tax.

Let's consider an example:

Chef John sells his restaurant (with real estate for $1,000,000) in Minneapolis to move to the much warmer Florida climate. He has identified a replacement restaurant property for $1,000,000 that includes all of the furniture, fixtures, and equipment (FF&E). As long as the value of that incidental property does not exceed $150,000, this property is not required to be separately identified and it will not count against the 3-Property Rule. It is important to note that this rule will only apply to identification. The replacement property is required to still be "like-kind" to the property that was sold (the relinquished property). For instance, if Chef John's relinquished real property was worth $1,000,000 and this new property is only worth $850,000 and includes incidental (the FF&E) property worth $150,000, that $150,000 of incidental property is "boot" and subject to tax due to the incidental property not being "like'kind" to the relinquished property (real estate).

Debt Requirements for Your Replacement Property

This is an important aspect of the 1031 exchange that many people fail to realize. Some key points include the fact that the replacement property has to be of equal or greater value (before closing costs) than the property you sold (relinquished property) in order for the proceeds to re-invested full tax deferral. This does not change if you are buying multiple properties. You just need to ensure that the aggregate of all the properties is equal to, or greater that, the relinquished property.

Now, if you are carrying a loan (debt) on the relinquished need to replace that too. If you take on less debt on your replacement property than you had on the relinquished property...that, my friends, is "mortgage boot" and that is taxable income.


What the heck is "boot"? Well, historically the word "booty" is a 15th century word of Germanic origin (bute - a "sharing of the spoils or exchange"). For the purposes of the 1031 tax deferred exchange, we are talking about "cash boot" and "mortgage boot". Remember, only "like-kind" property may be exchanged...anything else is "boot" and you will be subject to tax as income.

Cash boot - in its simplest form, cash boot is receiving cash from a 1031 exchange. If you sell your relinquished property for $1M and buy another piece of real property for $900K, the $100K you receive is income. Simple enough. However, sometimes a tax payer purchases a property that needs improvements. So, let's say you buy that $900K property, but it needs $100K in improvements. Well, that doesn't count...remember, it has to be "like-kind".

Mortgage boot - we went over this to some extent earlier, but to put it simply, this just means that the debt you take on for your new property must be equal to, or greater than, what you held on your relinquished property. If you carried a $400K note on your relinquished property, you need to carry $400K or more on your new property(ies).

Now, when it comes to "boot", you can always add fresh cash to avoid a tax consequence. In the case above, you could pay for the $100K in improvements out of your pocket and not be subject to the tax. The same would apply to mortgage boot.

Here are a few allowable expenses for closing costs in a 1031 exchange:

* Recording/Filing fees

* Attorney expenses related to the transaction

* Escrow and settlement fees

* Owner's title insurance premiums

* Qualified Intermediary(QI) fees

* Real estate broker commissions

* Tax adviser fees (related to the acquisition)

* Finder or referral fee

* Doc stamp taxes

Some non-allowable fees:

Any fees related to financing. This would include appraisal costs, mortgage insurance, lender's title insurance premiums, loan processing fees, points on the loan, loan fees, etc.)

* Property taxes

* Prorated rents

* Insurance premiums

In closing, let's go back to our original example with Ms. Investor...

Ms. Investor found a suitable replacement property and reinvests her $2,600,000 into a new investment that yields a 6% return, equating to an annual cash-flow of $156,000. Assuming Ms. investor did not do a 1031 tax deferred exchange, she would have $2,054,350 to work with (from earlier example). This means that to make that same $156,000 in income, Ms. Investor would need to purchase a replacement investment property that yielded a minimum 7.5% return in order to receive the same annual cash-flow of $156,000. Think about that. This could significantly limit your investment choices and push you into investment sectors where more risk must be realized...not to mention the added taxes paid.

Want more information on how a 1031 tax deferred exchange may work for you? Give us a call or email. The Coffey Group are experience 1031 Exchange real estate advisers who can assist you in the sale and purchase of your next commercial or residential investment property.