Practical Tips for Navigating 1031 Exchanges
Tax-deferred 1031 exchanges remain one of the most powerful strategies for real estate investors to preserve equity, reinvest gains, and build long-term wealth. Given both federal and state tax rates, the incentive to defer capital gains through a properly structured exchange has never been stronger.
Since the Tax Cuts and Jobs Act of 2017, 1031 exchanges are limited to real property held for investment or use in a trade or business. That means the strategy no longer applies to personal property such as equipment, aircraft, or livestock but remains highly effective for real estate investors seeking to expand their portfolios while managing tax exposure.
Here are a few practical tips to help your clients maximize the benefits of a 1031 exchange.
Don’t Touch the Money
One of the most important principles of a valid exchange is that the seller must not take possession or control of the proceeds from the sale of the relinquished property. If your client, even momentarily receives the funds, the transaction becomes a taxable sale.
To stay compliant, a Qualified Intermediary (QI) should be engaged prior to closing. The QI holds the proceeds and facilitates the exchange under strict IRS rules (specifically, the G(6) limitations), which prevent the taxpayer from accessing, pledging, or otherwise benefiting from the funds during the exchange period.
Put simply: once the sale closes, the proceeds must go straight into the QI’s hands, never the taxpayer’s hands.
Use a Qualified Intermediary (QI)
A QI is a neutral third party responsible for safeguarding the sales proceeds and using them to acquire the replacement property. The taxpayer conducting the 1031 exchange must:
- Identify potential replacement properties within 45 days of the sale, and make sure they have this in writing.
- Acquire one or several of the properties they identified within 180 days.
Both timelines (45-day and 180-day) will begin the day after the closing of the relinquished property. Missing either deadline may disqualify the exchange and may result in a taxable event.
Understand the Replacement Property Rules
When identifying replacement property, taxpayers can choose from several options:
- Three Property Rule: Identify up to three potential properties, regardless of the value of each property.
- 200% Rule: Identify more than three properties as long as their total fair market value (FMV) does not exceed 200% of the value of the relinquished property.
- 95% Exception: Identify any number of replacement properties if the FMV of the properties received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties that were identified. This means that when using this rule, 95% (or all) of the identified properties must be purchased, or the entire exchange becomes invalid.
Careful documentation and timely identification are essential. There’s no grace period for errors or omissions.
Be Cautious with Seller Financing
A core requirement of a 1031 exchange is that the seller reinvest both the netproceeds and equity from the sale into like-kind property. Offering seller financing, such as accepting a promissory note in lieu of cash, can reduce the amount of money available to reinvest, creating taxable “boot.”
If seller financing is necessary, one workaround is for your client to provide a separate, personal loan to the buyer, rather than using exchange proceeds. This can preserve the full amount of proceeds for reinvestment and may avoid unintended tax consequences.
Defer . . . Defer . . . Defer . . . then Die
Many investors build their real estate portfolios using a “laddered” 1031 strategy: start with a small rental property, exchange into a duplex, then a fourplex, and eventually into commercial or multifamily properties, deferring gains each time.
So, what happens to all that deferred gain when the investor dies?
Thanks to IRC §1014, heirs receive a step-up in basis to the FMV at the date of death. This means the accumulated deferred gains may be permanently eliminated when the property is inherited and no capital gains tax owed. It’s a compelling strategy for wealth preservation.
However, while capital gains may be avoided, estate taxes still apply for high-net-worth individuals. Life insurance is often a smart planning tool to provide estate liquidity and avoid forced sales of real estate during periods of market downturn. Life insurance death benefits are generally income tax–free under IRC §101, making them another efficient complement to 1031 strategies.
Planning Ahead with Partnerships: “Drop ‘n Swap” Strategies
IRC §1031 generally excludes partnership interests from eligibility for exchange. Many investors hold real estate in LLCs or partnerships, which can complicate matters, especially if different partners have different tax goals.
Early planning can help avoid conflict and maximize tax efficiency.
Option 1: Full Drop to Tenancy-In-Common (TIC)
Before a sale, deed the property from the partnership to individual partners as TIC owners. This gives each partner direct ownership and the ability to pursue their own exchange. It may be important to allow enough time between the “drop” and the sale to establish valid investment intent and meet holding requirements, depending on the state in which your relinquished property is located.
For example, a recent decision from the New York Division of Tax Appeals offered a favorable opinion for 1031 exchange with a no holding period NY Drop and Swap. (DETERMINATION DTA NOS. 850122 AND 850123) This means no holding period was necessary to comply with the investment intent requirement under 1031.
Check with lenders beforehand to avoid violating due-on-sale clauses. And you may need to update your insurance certificate to ensure all TIC owners are listed as additional insured parties.
Option 2: Partial Drop for Diverging Goals
If only some partners wish to cash out while others want to exchange, redeem the non-exchanging partners’ interests. They become TIC co-owners with the remaining partnership, receiving their share of proceeds (and recognizing gain), while the partnership continues with a 1031 exchange. Each TIC owner should get a separate 1099-S upon the sale closing for their proportionate share of the proceeds. The optics look best when the sale contract is entered into by all TIC owners as co-sellers.
Final Thoughts
The benefits of a 1031 exchange are significant, but the rules are strict. The key to success is advance planning. Identify potential exchange opportunities early, structure ownership accordingly, and educate clients about timelines and requirements.
1031 exchanges aren’t one-size-fits-all. With the right guidance, they become a powerful tool for wealth preservation and tax efficiency.
Source: RE Journals
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