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1031 Exchange Options

May 12, 2024

A 1031 exchange allows real estate investors to defer capital gains taxes when they exchange one investment property for another. As provided by the Internal Revenue Service (IRS), there are different ways you can achieve this tax deferral through the 1031 exchange. Each option has its unique procedures and requirements; that’s why you need to understand how each type of 1031 exchange works to identify the option that is best for your investment goals.

At Universal Pacific 1031 Exchange, we’re committed to helping you maximize your 1031 exchange tax benefits and increase your investment return. Our experienced Qualified Intermediaries are always here to help you find out the type of exchange that is most suitable for you and guide you throughout the process. Book a free consultation with us today to get started.

This blog will cover the different types of 1031 exchanges, how they work, and how a qualified intermediary can help you maximize the benefits of the exchange.

What is 1031 Exchange?

What is 1031 Exchange?

A 1031 exchange is a strategy that allows real estate investors to postpone capital gains taxes when they exchange an investment property for another like-kind replacement property. It is named after Section 1031 of the U.S Internal Revenue Code. This tax strategy is used primarily in real estate but can apply to certain other types of assets.

The 1031 exchange process involves selling one property and reinvesting the proceeds into another property. To successfully defer capital gains taxes using this strategy, you must adhere to specific rules stipulated by the IRS. For instance, you must complete the transactions within the IRS timeline for 1031 exchanges. Moreover, the replacement property must have equal or greater value than the relinquished property. Additionally, you must also identify replacement properties in keeping with the rules for identification.

Types of Properties That Qualify For a 1031 Exchange in California

Only investment properties qualify for tax-deferred exchanges. In this context, an investment property is a real estate property that is used for the purpose of business or investment. These properties include residential apartments, commercial buildings such as offices and shopping complexes, industrial buildings such as warehouses, or undeveloped land held for appreciation. Properties primarily held for personal use, like primary residences or vacation homes, do not qualify unless they meet specific usage criteria set by the IRS.

Another important requirement to note is that both the relinquished property and the replacement property must be “like-kind”. According to the IRS, two properties are like-kind if they have the same nature or character, regardless of their quality or grade. For example, a rental apartment building is like-kind to another rental property or even an empty land as long as both are for business or investment purposes.

1031 Exchange Timeline and Extension

1031 Exchange Timeline and Extension

According to the IRS, you have a total of 180 days from the sale of the relinquished property to complete a tax-deferred exchange. The timeline comprises of a 45-day identification period, during which you’re expected to have identified a suitable replacement property for the exchange. Then, you have the remaining 135 days to purchase the replacement property and finalize any other part of the deal. If you fail to comply with this timeline, your transactions may be disqualified from tax deferral.

How to Get a 1031 Exchange Timeline Extension

The IRS is strict with the 180-day timeline for 1031 exchanges. This means that, generally, you cannot get a timeline extension for 1031 exchanges. However, there are a few instances where you may be able to get extensions. Such instances include:

  1. Federally Declared Disasters: You can get an extension of up to 120 days or more if your real estate investments are affected by a federally declared disaster. The exact number of extra days you get depends on the nature of the disaster and how much it affected your transactions.
  2. Extension of Tax Return Filing Deadline: Filing an extension for your tax return does not automatically extend the 180-day timeline unless it falls within the normal tax filing deadline. However, filing an extension for the tax return can effectively extend the exchange deadline to October 15 if the 180 days would otherwise end before that date.
  3. Service in a Combat Zone: Taxpayers who are serving in a combat zone or participating in contingency operations may receive extensions on performing certain acts under the tax law, including completing a 1031 exchange.

How to Apply for an Extension

The IRS usually announces the steps, guidelines, and deadlines for most federally declared disasters. To apply for an extension, you have to follow the announcements for that particular disaster. To extend the tax return filing deadline, you would need to file Form 4868 with the IRS before the original due date of your tax return.

It’s advisable to stay up-to-date with IRS announcements to know the right steps to take before applying for a 1031 exchange extension. Additionally, consult with a tax advisor or a qualified intermediary who specializes in 1031 exchanges to ensure compliance with the updated deadlines.

What are the Benefits of 1031 Exchanges in California?

There are several advantages of a 1031 tax-deferred exchange provided that you adhere to all the requirements. They include:

  1. Deferring Capital Gains Taxes: The primary benefit of a 1031 exchange is the ability to defer capital gains tax on the profit from the sale of an investment property. This allows you to use the full amount of your equity to invest in another property, rather than paying a portion in taxes.
  2. Growing Your Investment: Since you can reinvest the full amount after selling a property, you have the opportunity to invest in more properties or properties with higher value. That way, you get to increase the overall worth of your portfolio and consequently, your net worth. Additionally, a tax-deferred exchange allows you to adapt to market changes by transferring your capital from older to newer properties without immediate tax liabilities.
  3. Planning Your Estate: If you inherit an investment property acquired through a 1031 exchange, you do so on a stepped-up basis. That way, the tax basis of the property is reset to the fair market value at the time of the owner’s death. The reset basis means you can potentially sell the property without paying incurring capital gains taxes. Hence, 1031 exchange offers an opportunity to pass on multifamily properties without any tax burden.

What is the 200% Rule in Tax-Deferred Exchanges?

What is the 200% Rule in Tax-Deferred Exchanges?

The 200% rule allows an investor to identify more than one potential replacement property. You can identify any number of properties as long as the total fair market value of all the properties identified does not exceed 200% of the fair market value of the relinquished property at the time of its sale.

For instance, say you sell an office apartment for $5 million. According to the 200% rule, you can identify as many properties as you want. But the total market value of all of those identified properties must not be more than $10 million, which is 200% of $5 million.

The purpose of the 200% rule is to allow investors to be flexible in choosing replacement properties. But at the same time, the rule aims to make sure that there is a limit to how much investors can expand the exchange. However, you can still identify more than three replacement properties regardless of their total value, but that must be under the 95% rule. The 95% rule implies that you must acquire at least 95% of the total value of your identified replacements if you identify more than 3 without regard for the 200% rule.

Types of 1031 Exchange Options Available in California

Types of 1031 Exchange Options Available in California

There are various types of 1031 exchanges in California. Each type of exchange has unique procedures to align with different investment situations. You need to learn the different types and understand the differences between them to help you make informed decisions that best align with your investment goals and risk tolerance. The different types of 1031 exchange are as follows:

1. Simultaneous Exchange

In a simultaneous exchange, you sell the relinquished property and acquire the replacement property in the same period. For a successful simultaneous exchange, you’ll have to follow the timeline very strictly. Since the exchange happens almost immediately, it’s important to make sure that transactions adhere to the relevant requirements of the IRS to avoid disqualification.

2. Delayed Exchange

This is the most common type of 1031 exchange. Here, you can sell your relinquished property before identifying the replacement property(ies). This allows you to take advantage of the 180-day timeline to have more time to process and finalize the exchanges properly. The primary benefit of this type is the flexibility and time it provides.

3. Reverse Exchange

The reverse exchange works opposite the way delayed exchange works. In this case, you have to acquire the replacement property before you sell the relinquished property. The new property must be held by an Exchange Accommodation Titleholder (EAT) until you sell the old property within the 180-day strict timeline. If you find a suitable replacement property before you’ve sold your property, then the reverse exchange might be the best option for you. For instance, when you exchange two properties for one, you can decide to first find a suitable property worth the value of both relinquished properties before you sell them.

4. Improvement or Construction Exchange

This is also known as a build-to-suit exchange. Here, you use the exchange money to improve the replacement property or construct new buildings on it. This must be completed within the 180-day period, and the total value of the property after improvements must meet or exceed the value of the relinquished property. This type of exchange is suitable for investors looking to customize properties to better fit their needs.

5. Fractional Ownership Exchange

You can also exchange into fractional ownerships in property, such as through tenancy-in-common (TIC) interests, Real Estate Investment Trust (REIT), or Delaware Statutory Trusts (DSTs). The Delaware Statutory Trust (DST) 1031 exchange combines the use of a Delaware Statutory Trust with the tax deferral benefits of a 1031 exchange.

The DST 1031 exchange allows multiple investors to pool their funds to own apportioned interests in real estate assets. Instead of directly using the money from the sale of one investment property to buy a new one, investors put their funds into a DST. This allows them to own a portion of the new property or a group of properties together with other investors. This setup lets multiple investors share ownership of one or more properties.

How to Chose the Best 1031 Exchange Option For Your Real Estate Portfolio

How to Chose the Best 1031 Exchange Option For Your Real Estate Portfolio

Different 1031 exchange types and options have their unique advantages or disadvantages. That’s why it’s important to understand how each of them works to enable you to make the right choice. Below is a summary of some steps you can take to be sure you’re implementing the right 1031 strategy for your investment.

First, define your investment goals. What’s your primary purpose for using the 1031 exchange? Are you looking to defer capital gains taxes or boost your portfolio? Clarifying your aim helps you choose the type that best fits your goals.

Secondly, be sure you understand how each type of exchange works, their requirements, and their timeline. Then, assess the current market conditions to see how the transactions may affect your investment; whether you need to buy first (delayed exchange) or sell first (reverse exchange).

Moreover, it’s advisable to consult with a Qualified Intermediary with experience in handling successful 1031 exchanges. Such QIs can assess your case and advise you on the type of 1031 exchange that is most suitable for your situation.

Common Pitfalls in a 1031 Exchange and How to Avoid Them

Common Pitfalls in a 1031 Exchange and How to Avoid Them

To maximize the tax benefits of the 1031 exchange, you need to beware of certain mistakes that can disqualify your transactions. Some of these pitfalls include:

  • Improper Management of Funds: As per IRS requirements, you’re not allowed to hold exchange funds. Instead, the QI holds the money in an escrow account. Failure to follow this rule may disqualify your exchange.
  • Exceeding the Timeline: You must adhere to the strict 180-day timeline to qualify for tax deferral. If you miss any of the deadlines, your exchange may attract immediate capital gains tax liabilities.
  • Incorrect Valuation of Replacement Properties: As mentioned earlier, the total value of your replacement properties must be equal to or greater than your relinquished property. Hence, you must be sure the properties are evaluated correctly to stay compliant.
  • Deferring Taxes on Boot: Boot in a 1031 exchange refers to the portion of the proceeds from the sale of the relinquished property that you did not reinvest into the new property. The boot is subject to tax. Therefore, not paying tax on boots may attract legal consequences.
  • Incorrect Identification of Replacement Properties: If you identify multiple replacement properties, you must make sure you follow the 200% rule, the 95% rule, and other relevant standards. Violating any of these rules can disqualify your transactions.

How a Qualified Intermediary Can Help You Navigate the Legal Landscape

The role of a Qualified Intermediary in carrying out a successful and compliant tax-deferred exchange cannot be overemphasized. It’s necessary to understand why you need to find a qualified intermediary to facilitate a smooth exchange and enjoy tax deferral benefits.

Qualified Intermediaries are experts in the legal requirements of a 1031 exchange. They understand how the tax code works in real estate transactions and the common mistakes that can deny you some tax benefits. Therefore, a QI has what it takes to help you avoid errors that may attract legal consequences. Beyond facilitating the exchange, a QI can also help you understand how the investment strategy works and the potential tax implications involved.

QIs also handle all necessary documentation, including the Exchange Agreement, assignment of sale and purchase rights, and formal identification notices for replacement properties. This thorough documentation is vital for maintaining the validity of the exchange.

Moreover, the investor is prohibited from handling exchange funds. You need a QI to hold the sale proceeds to make sure you don’t have a constructive receipt of the money. As a third party, the QI also helps ensure that the entire process is fair and transparent.

Contact Universal Pacific 1031 Exchange to Grow Your Real Estate Portfolio

To successfully defer capital gains taxes using the 1031 exchange, you must understand how the strategy works and the key requirements you need to fulfill. It’s also necessary to know the different options of 1031 exchange available so you can choose the type that best suits your investment goals. As you run the exchange, make sure you’re aware of the common pitfalls that may deprive you of the tax benefits.

Working with a Qualified Intermediary is key to facilitating a smooth and compliant exchange. As the best Qualified Intermediaries in Los Angeles, Universal Pacific 1031 Exchange is always available to help you understand how and what common mistakes to avoid. We will make sure your exchange transactions are transparent, fair, and comply with the relevant regulations. Book a free consultation with us today to start an exchange.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.