1031 Exchanges: A Practical Guide for Real Estate Agents and Their Clients

This article is written by 1031X.com, Inc., a qualified intermediary headquartered in Denver, Colorado, that has been conducting 1031 exchanges across the nation for almost 31 years. This article is intended to be a broad educational overview of some key aspects of 1031 exchanges which involve complex legal, tax, investment and real estate laws, concepts, and principles. Nothing in this article is intended to be, and should not be construed, used, or interpreted, as legal, tax, investment, or real estate advice. Please always consult your own legal, tax, investment and real estate advisors and professionals, as applicable, who are familiar with your own unique situation and facts. This article is not endorsed by and does not necessarily reflect the opinions of CAR.

It’s true that a lot of real estate agents know about 1031 exchanges, but the details and strategic applications can often be confusing and feel daunting. The most effective agents aren’t experts in the tax code, but rather they are knowledgeable enough to spot opportunities and provide actionable information.

In this article, we will break down several must-know rules, clarify common misconceptions, and show how 1031 exchanges can address real client challenges. Think of this as a cheat sheet to help better position yourself as a more knowledgeable 1031 exchange “conversationalist”.

Before diving in too far, let’s get some basics out of the way. First, 1031 exchanges are designed to help real estate investors with their investment properties; they are not a tool for buyers and sellers of primary residences or for (most) vacation properties (for help with primary residences, look to IRC Section 121) . Second, 1031 exchanges are intended for long-term investors, which means developers, dealers, and flippers may struggle to qualify. However, if you are working with a typical retail or institutional investor, the following knowledge could go a long way to impressing your audience.

The Essential 1031 Rules And What They Mean For Your Clients

•Defer Taxes to Fuel Growth: At their core, 1031 exchanges allow investors to defer taxes (including state taxes, capital gains taxes, depreciation recapture taxes, and NIIT taxes). If your client sells an appreciated investment property, they would normally pay taxes on the profit. However, with a successful 1031 exchange, your client can defer these taxes and reinvest the proceeds instead, allowing them to unlock greater return on their investment.

• Ticking Clock: 1031 exchanges operate on strict deadlines. Unless a qualifying natural disaster is declared, your clients have only 45 days from the sale of their property to identify potential replacements and only 180 days from sale to acquire their next property.

•Begin Your Exchange by Consulting With a Qualified Intermediary First: Except in the rarest of circumstances, your clients cannot start a 1031 exchange if they already sold their property or received their sale proceeds. That’s why clients need to find and retain a Qualified Intermediary (QI) before they close on a property that will be involved in a 1031 exchange. This is a simple but critical timing issue that is often overlooked and can disqualify a 1031 exchange.

• The Role of a Qualified Intermediary: A taxpayer transacting a 1031 exchange should engage a qualified intermediary (QI) prior to the sale of real estate. However, it is also very important to emphasize what the role of a QI is. A QI is not a law firm or legal advisor, not an investment advisor, not a real estate broker, and not a CPA or an accountant. The role of a QI is solely to facilitate, coordinate, and administer the exchange process. It does not provide legal, tax, investment, or real estate advice.

Your client should seek and obtain their own and separate and independent advice from applicable qualified advisors who are appropriately licensed in their specific respective professions; namely, lawyers, CPA’s, investment advisors, and real estate professionals. Think of the QI as the facilitator and the administrative quarterback of a 1031 exchange.

•Buy “Like-Kind” Property: When your client sells an investment property in a 1031 exchange, they have to replace it by buying property(ies) of “like-kind.” The term “like-kind” often leads to misunderstandings. Virtually all types of real property held for business or investment purposes can be “like-kind” to each other. It's not about swapping one property for an identical replica. Your clients do not need to exchange a condo for a condo, or an apartment building or another apartment building. They can sell a farm and buy a condo. Or sell a duplex and buy a single-family home, and so forth. The list of what qualifies as “like-kind” includes, but is not limited to…

•Residential rental properties (single-family homes, apartment buildings, etc.)

•Commercial real estate (office buildings, retail space, warehouses, etc.)

•Industrial property

•Farmland

•Raw land

•Certain mineral rights, easements, riparian and water rights, air rights above buildings, and other rights.

•and more.

The point here is that clients can mix and match different types of qualifying investment real property. This flexibility allows real estate investors to strategically utilize 1031 exchanges to diversify their holdings, change or upgrade property types, change locations, or adapt their portfolios based on market conditions and personal goals.

BUSTING COMMON MYTHS & MISCONCEPTIONS

Navigating the complexities of 1031 exchanges can be daunting, and misconceptions about the process abound. As a real estate agent, understanding a few key rules and clarifying common misunderstandings will help you guide clients with confidence.

MYTH #1: “YOU ONLY NEED TO REINVEST THE NET CASH OR PROFIT FROM SALE”

This is a very common misunderstanding. It is true that the IRS requires that your client reinvest all net cash proceeds from their sale to receive full tax deferral in an exchange; the IRS also requires that your client acquire replacement property(ies) that are at least as valuable as what they sold. Suppose that your client sells a $500,000 property with $300,000 worth of net equity. In order to fully defer taxes in a 1031, the client would need to transfer all $300,000 into the new property, and the new property would have to be worth at least $500,000. To the extent that your client falls short of either reinvesting the $300,000 or failing to buy $500,000 of new property, the difference can become taxable.

MYTH #2:“YOU MUST TRADE EQUAL OR UP IN DEBT”

You will read this all over the internet: “You must replace the debt on your old property with equal or greater debt on the new property.” And while there is some technical basis for this claim, in a practical sense it’s not always true. Your client can replace some or all of the value of their old debt by bringing in more outside cash (or other consideration) on the new property.

MYTH #3: “REAL ESTATE MUST BE USED SIMILARLY TO BE ‘LIKE-KIND’”

Effectively, any real property held for investment can be considered “like-kind” to your client’s property. They can trade out of farmland into a commercial shopping center, or from residential rentals to a gas station. Your client can also (subject to certain rules and limitations) trade out of active management situations into certain passively managed real property, such as investment deal syndications.

MYTH #4: “VACATION HOMES ARE 1031-ELIGIBLE”

Unfortunately, no, not always. There are specific conditions and use limits. These types of homes only qualify for 1031 treatment if your client’s personal use is limited no more than 14 days per year, or 10% of the days that the property was rented out, whichever is greater. (For example, a property rented for 200 days per year would allow for 20 personal use days per year to remain eligible for 1031 treatment.) It’s also best if the property was owned for at least 24 months prior to sale and there were at least two weeks of rental income in each of the prior two years.

MYTH #5: “YOU MUST OWN YOUR PROPERTY 2 YEARS BEFORE SELLING OR 2 YEARS AFTER BUYING IN A 1031”

This myth causes a lot of confusion and can lead to poor decisions and outcomes. It is not true that every 1031 property must be owned for 24 months before/after an exchange. The IRS only requires that, for any property involved in an exchange, the intent is to hold it for longterm business or investment use. Many exchanges occur with properties owned less than 24 (or even 12) months prior to sale/purchase. That said, longer holding periods are a great way to demonstrate the correct intent, and the rules can change if you’re trading properties with related parties. If your client is dealing with a property that has a short holding period, direct them to consult with a tax advisor.

MYTH #6: EXCHANGES ELIMINATE TAXES

It's essential to remember that 1031 exchanges defer taxes, not eliminate them entirely. However, strategic use throughout an investor's lifetime can have significant legacy planning benefits. Most notably, if properly structured, real estate passed on to your client’s heirs will receive a ‘step-up’ in tax basis at the time of the inheritance. This effectively eliminates all capital gains accrued up to that point, including capital gains taxes that were deferred in a series of multiple or successive 1031 exchanges. Some 1031 strategies may ultimately end with a tax bill; some won’t. It’s all about planning.

MYTH #7: “YOUR PURCHASE AND SALE AGREEMENT NEEDS TO INCLUDE 1031 LANGUAGE”

This is an extremely common misconception. The IRS rules state that the counterparty to any exchange transaction must be alerted about the exchange itself – but the rules don’t state how to deliver that alert. Many advisors suggest putting additional 1031-specific language in the purchase agreement or offer letter, but sometimes this can spook a seller or their agent if they mistakenly assume that the 1031 exchange will cost them money or add complexity to their sale. Consult with a QI for some thoughts and possible alternative notice methods allowable by the IRS.

1031 EXCHANGES IN ACTION: SOLVING REAL-WORLD CLIENT PROBLEMS

SCENARIO #1: THE OVERWHELMED LANDLORD WHO WANTS TO EXCHANGE INTO PASSIVE INVESTMENT

Are your clients tired of dealing with tenants, repairs, and the constant demands of hands-on property management? A 1031 exchange could allow your client to sell and reinvest in easier asset(s), such as a larger, professionally managed property. Doing this could mean more income, fewer headaches, increased free time, and freedom from restrictive legal jurisdictions.

SCENARIO #2: THE INVESTOR WHO WANTS TO DIVERSIFY THEIR PORTFOLIO

Are your clients worried about having too much of their investment portfolio tied up in a single market, property type, or geographical location? Your client may want to consider selling their appreciated property and use a 1031 exchange to diversify across multiple locations or property types. They could spread their investment across different states, ideally reducing risk exposure to local economic downturns or market fluctuations.

SCENARIO #3: THE CLIENT WHO WANTS TO RELOCATE TO A NEW STATE.

Clients relocating to a new state, with different tax rates and laws, may want to re-align their real estate holdings with their new location and lifestyle goals. A 1031 exchange lets them sell properties without incurring a tax hit, reinvest more proceeds in their desired market and keep their investment journey on track.

Scenario #4: The ambitious investor who wants to maximize their return on equity

Clients may own highly-appreciated properties but desire a stronger cash flow to match their current needs. A 1031 exchange could allow them to unlock that equity by reinvesting in one or more incomeproducing properties that better suit their current investment objectives. This "leveraged exchange" strategy puts their equity to work, potentially boosting overall returns long-term.

SCENARIO #5: THE GENERATIONAL INVESTOR WHO IS SERIOUS ABOUT ESTATE PLANNING

A savvy investor is focused not just on their own wealth growth, but on legacy planning for future generations. 1031 exchanges, used strategically throughout their lifetime, can minimize the tax burden passed down to their heirs. By deferring capital gains taxes, and possibly benefiting from a "stepped-up" tax basis upon death, your clients can preserve more of their hard-earned wealth for their beneficiaries.

AGENT

Agents and brokers don’t need to be experts in the tax code in order to leverage 1031 exchanges to help their clients. Even a small amount of knowledge can reveal new opportunities or help avoid potentially costly mistakes. Also, keep in mind that every 1031 sale could lead to another 1031 purchase (or two), which could mean more business for the savvy agent. This article should better equip you, and we hope it helps make you a better 1031 exchange “conversationalist.

AUTHORS:

Sean Ross, CEO: Before assuming his current role as CEO, Sean joined 1031X in 2016 to spearhead business development, technological development, and client servicing. Born and raised in Colorado, he earned a B.S. in Economics and a B.S. in Political Economy from Regis University. He spent the next 10 years working as an entrepreneur, retail banker, investment advisor, and editor for several financial publications. As an author, Sean has bylined more than 3,000 articles on the topics of investment, taxes, debt, real estate, and private capital.

Paul Hart, General Counsel & VP: Prior to joining 1031X, Paul was VP/EVP and General Counsel of several software, technology, and sports-media companies, several of which went on to be acquired. He has nearly a decade of "big law" firm experience in Silicon Valley as a corporate securities attorney doing venture capital financing deals, IPO’s, M&A, as well as contracts, licensing, and general corporate representation. He earned a JD and an MBA from UCLA.

Jeremy M.H. Fahl, Strategy and Implementation Manager: Jeremy cut his teeth in the real estate industry by representing banks at foreclosure sales while working through a Clevelandbased law firm in 2003. Jeremy pivoted to the title industry working mainly as a workflow analyst and product manager in residential and commercial title. Jeremy turned his attention to the 1031 exchange industry in 2012 to help streamline and simplify the process for taxpayers and their advisors. Since that time, Jeremy has successfully and personally facilitated over 5,000 exchanges nationally.

1031x.com, Inc. ("1031X") is a nationwide 1031 Qualified Intermediary. Over the course of the last 31 years, 1031X facilitated more than 12,000 exchanges representing more than $5 Billion in real estate value. Our staff includes real estate brokers, licensed attorneys, former financial advisers, and title officers, each dedicated to safeguarding your real estate investments from unnecessary tax burdens. Whether you're initiating forward exchanges or exploring the complexities of reverse and construction exchanges, or looking into the strategic advantages of a 721 UPREIT, 1031X offers tailor-made solutions to meet your needs. Member of the Federation of Exchange Accommodators. CES® (Certified Exchange Specialists) on staff.

www.1031x.com

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