Is a 1031 Exchange Right for Your Sale?

Most owners ask how to do a 1031 exchange. The better first question is whether to do one at all, and the answer depends on numbers most owners haven’t run yet.

What an exchange actually defers

A 1031 exchange generally lets you exchange real estate held for investment or business use for other like-kind real estate and defer the tax on the gain. A plain sale followed by a separate purchase doesn’t qualify. The key word is defer. The deferred gain carries into the replacement property through a lower tax basis and is generally taxed when you later dispose of that property in a taxable transaction.

Two consequences are easy to miss. Depreciation recapture is generally deferred along with the gain, not erased, though boot can trigger some of it in the year of the exchange. And a lower basis means smaller depreciation deductions on the new property going forward.

When paying the tax can be the better answer

An exchange is a tool, not a default. Paying the tax can make more sense when:

• The gain is small compared with the cost of the exchange: intermediary fees, a rushed purchase, or a property you wouldn’t otherwise buy

• You have losses or carryforwards that would absorb the gain

• You want cash out of the deal anyway

• Nothing in the market is worth buying at a fair price inside the deadlines

The most expensive outcome is overpaying for a replacement property to avoid a tax that was smaller than the overpayment.

Boot: how part of an exchange becomes taxable

To defer all of the gain, you generally need to buy replacement property of equal or greater value, reinvest all of your net equity, and replace any debt paid off with new debt or additional cash. Anything you walk away with is boot, and boot is generally taxable up to the amount of your gain. It usually shows up in one of three ways:

• Cash left over at closing that isn’t reinvested

• Debt paid off on the sale that isn’t offset by new debt or additional cash you put in

• Exchange proceeds used for costs that aren’t treated as exchange expenses

An exchange can still work while part of it is taxed. That’s often fine, as long as it’s a decision and not a surprise.

The 45-day and 180-day deadlines

The clock starts the day you transfer the property you’re selling, and both periods run in calendar days.

Day 45: identify replacement property in a signed writing delivered to your qualified intermediary or another permitted party. Many owners use the three-property rule, which allows up to three properties of any value. Two alternatives allow more: properties worth no more than 200% of what you sold, combined, or any number if you acquire at least 95% of the value you identify.

Day 180: close on the replacement. If the seller’s tax return for the year of the transfer is due before day 180, the exchange period ends on that due date unless the return is extended. When an LLC or partnership is the seller, that’s the entity’s return.

Neither deadline moves for weekends or holidays. You also can’t receive or control the sale proceeds during the exchange. They’re typically held by a qualified intermediary, and taking control of the cash can end the exchange or make part of it taxable.

State rules, including California

Most states follow the federal exchange rules, but not all treat out-of-state exchanges the same way. California tracks gain from California property that’s exchanged into property in another state. If you exchange out of state, you may have an annual California filing (Form FTB 3840), and California still taxes that deferred gain when the replacement property is eventually sold.

Questions to answer before you list

• What is my adjusted basis, and what is the tax if I simply sell?

• How much debt is on the property, and can I replace it?

• Do I want any cash out of this sale?

• Is there replacement property I would actually buy?

• Is anyone on either side of the deal related to me? Related-party exchanges generally carry a two-year holding requirement, with limited exceptions.

If you can’t answer the first question quickly, that’s the place to start.