Under Internal Revenue Service code section 1031, investors who exchange ownership of real property for a like or similar property can preserve wealth by deferring capital gains taxes and depreciation recapture. Since there are four different ways investors can rollover the proceeds from relinquished assets into new properties, it’s important to have an exchange strategy in place prior to selling any existing assets.
The Main 4 Types of 1031 Exchanges
Investors can use one of these four common 1031 exchange methods when relinquishing real property for new assets:
1. Two-Party Simultaneous Exchange
Simultaneous exchanges are the oldest of these four 1031 exchange methods. Two property owners agree to swap deeds and ownership interest of their properties. While this method eliminates the need to find buyers, it’s usually very difficult for exchangers to find fair-market-value properties with matching debt and equity structures. Delays in ownership transfer can also negatively impact the integrity of the swap and expose exchangers to serious liability.
2. Delayed Exchange
Delayed exchanges are the most common form of 1031 exchanges. Exchangers have 45 days to identify a like-kind replacement property and must close on the property within 180 days. These two timelines are usually non-negotiable with the Internal Revenue Service; however, the IRS issued Notice 2020-23, which extended these deadlines in certain instances due to the COVID-19 pandemic.
3. Reverse Exchange
This type of exchange occurs when exchangers acquire a like-kind replacement property prior to fully relinquishing ownership of current assets. Since exchangers cannot simultaneously have ownership of their relinquished property and the target asset, they must have an Exchange Accommodation Titleholder (EAT) temporarily take possession of the relinquished or target property via a special purpose entity such as a single-member LLC. The EAT then takes possession of either the relinquished property or target property under a Qualified Exchange Accommodation Agreement.
4. Construction/Improvement Exchange
Under this method, exchangers can make improvements on a target asset using their equity generated from the exchange. Exchangers can either refurbish or make capital improvements to existing real property, or build new from the ground up. Improvement exchanges can significantly enhance the value of the acquired property.
However, the improved or new replacement property must have the same value as the relinquished property. And the 45- and 180-day deadlines still apply, which can complicate this type of exchange transaction since exchangers have just under six months to complete all capital improvements.
Other 1031 Exchange Strategies
A fifth method, personal property exchanges, used to be more common, but the IRS limited like-kind exchanges to real property with the passing of the Tax Cuts and Jobs Act effective January 1, 2018. Previously, exchangers could include assets such as aircraft, boats, machinery, or equipment in personal property exchanges.
At their core, each one of these exchange methods is executed to defer capital gains taxes while also potentially generating passive income from target assets. Each exchange method has its own intricacies and opportunities, and real estate investors should carefully weigh the pros and cons of each option before initiating the 1031 exchange process.
Realized is the end-to-end partner for investment property wealth management. The company aims to make it easy to transform individual property assets into investment property wealth solutions.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
