Timing and 1031 exchanges

They say real estate success is all about location, location, location. It could also be argued that it is about timing, timing, timing. Finding a great investment property is about location, but also about timing. Timing is equally important in a §1031 exchange. To defer the capital gain taxes on the sale of one property and the purchase of another, a §1031 exchange must be set up before either the relinquished property or the replacement property closes. After either property closes, it is too late. It is therefore important to understand the timing and follow the deadlines.

From the date of closing on the relinquished property, the investor has 45 days to identify potential replacement properties, and a maximum of 180 days to acquire them. The investor must identify the replacement property before midnight on the 45th day, and must acquire one or more of the identified properties within a maximum of 180 days.

The replacement property must also be purchased before the investor files their tax return for the year in which the exchange began. This means that if the exchange begins late in the year (typically October 19 to December 31 for an individual taxpayer), it will either need to be completed before the investor’s tax filing deadline (typically April 15), or the investor will need to file for an extension of time to file their tax return in order to have the full 180 days.

Finally, the same rules apply in a reverse exchange, where the replacement property closes first, except that it is the relinquished property that must be identified within 45 days and closed within 180 days.

Requirements for full tax deferral

Many real estate investors are confused about what they need to do to fully defer capital gain, and the payment of capital gain taxes, in a §1031 exchange.

Consider an investor who sells a shopping center for $2 million. Their capital gain is $500,000. At closing, the outstanding mortgage of $1 million is paid. After closing costs, $800,000 is sent to the qualified intermediary for reinvestment. When the investor purchases the replacement property, do they just need to reinvest the profit? Do they need to match the debt? Or just the cash received from the sale? The answer is none of the above.

To fully defer capital gain in a §1031 exchange, an investor must:

  1. Acquire replacement property that costs as much as or more than the relinquished property, less closing costs; and
  2. Spend all of the net proceeds from the sale of the relinquished property on the purchase of the replacement property.

Both the investor’s cost basis and capital gain must be reinvested. This means the investor will need to either obtain a mortgage to offset the difference between the purchase price and the funds available, or spend additional cash from other sources in lieu of new debt. Any proceeds from the sale not spent, and any reduction in mortgage debt not replaced with additional funds, will be “boot” in the exchange and subject to taxation.

Here is an exchange in which capital gain is deferred in full:

  • Relinquished property: sales price $2,000,000, less mortgage payoff of $1,000,000 and closing costs of $200,000, leaving net equity of $800,000.
  • Replacement property: purchase price $3,000,000, financed with a new mortgage of $2,200,000 and a down payment of $800,000.
  • Boot: $0.

That is not to say an investor must defer all gain to complete a §1031 exchange. Partial exchanges are permissible. However, any boot is subject to taxation, as follows:

  • Relinquished property: sales price $2,000,000, less mortgage payoff of $1,000,000 and closing costs of $200,000, leaving net equity of $800,000.
  • Replacement property: purchase price $1,500,000, financed with a new mortgage of $800,000 and a down payment of $700,000.
  • Boot: $200,000 of mortgage boot and $100,000 of cash boot.

In this instance, $300,000 would be subject to taxation ($200,000 mortgage boot plus $100,000 cash boot).

If you need guidance on your particular situation, call the experts at Madison 1031, a qualified intermediary, to discuss whether a §1031 exchange makes sense for your real property.