Section 1031 exchange
Also called 1031 exchange, Like-kind exchange, Deferred exchange.
A section 1031 exchange lets an owner defer capital gains tax and depreciation recapture on the sale of investment real property by reinvesting the proceeds into like-kind replacement property within statutory deadlines. It is a deferral, not a forgiveness: the deferred gain carries into the basis of the new property.
How it works
The deadlines are strict and are the most common point of failure. Replacement property must be identified in writing within 45 days of the sale closing and acquired within 180 days, and the two clocks run concurrently from the same date rather than sequentially. Missing either one makes the sale fully taxable.
Two structural requirements determine whether the deferral is complete. Proceeds must pass through a qualified intermediary and never be received by the seller, or the exchange fails on constructive receipt. And to defer the entire gain, the replacement property generally has to be of equal or greater value with equal or greater debt, so any value not reinvested, or any reduction in debt not replaced with cash, is boot and is taxable.
For underwriting, the effect is on the after-tax exit rather than on operations. A deferred exchange preserves the full sale proceeds for reinvestment, which is a real and often large economic benefit, at the cost of a lower basis on the replacement asset and therefore smaller future depreciation deductions and a larger eventual gain. Rules for exchanges are detailed and this is a description of mechanics, not tax advice.
Worked example
Illustrative, carrying the recapture example forward: sale price $62,656,017, adjusted basis $47,769,091, accumulated depreciation $8,130,909. Illustrative rates of 25 percent on unrecaptured section 1250 gain and 20 percent on capital gain, before any state tax and before net investment income tax.
| Total gain | $14,886,926 |
|---|---|
| Tax on unrecaptured section 1250 gain | $2,032,727 |
| Tax on the remaining capital gain | $1,351,203 |
| Total federal tax deferred | $3,383,930 |
| Basis carried into the replacement property | reduced by the deferred gain |
| Additional capital available to reinvest | $3,383,930 |
About $3.4 million of federal tax deferred and therefore still working. Measured against the $19,565,000 of equity originally invested, that is roughly 17 percent more capital carried into the next deal. The cost is a lower basis on the replacement property, which means smaller depreciation deductions and a larger gain whenever the chain finally ends.
Conventions worth knowing
- 45 days to identify and 180 days to close, running concurrently from the closing of the sale. Neither is extendable in ordinary circumstances.
- Trade equal or up in both value and debt, or the shortfall is boot and is taxable.
- Since 2018 only real property qualifies. Personal property exchanges no longer do, which interacts directly with a cost segregation position.
The common mistake
Treating the exchange as tax-free rather than tax-deferred
The deferred gain reduces the basis of the replacement property, so the new asset carries smaller depreciation deductions and a larger built-in gain from day one. A model that shows an exchange as a clean escape from the exit tax overstates the benefit and understates every future year's taxable income. The correct treatment is to carry the deferred gain forward as a basis reduction and to keep reporting the deferred amount as an outstanding liability against the position. Tax treatment depends on individual circumstances and this is a description of mechanics, not tax advice.
Related terms
- Depreciation recaptureDepreciation recapture is the portion of the gain on sale attributable to depreciation previously deducted, taxed at a rate above the long-term capital gains rate. For real property the recaptured amount is unrecaptured section 1250 gain, subject to a statutory rate cap of 25 percent.
- DepreciationDepreciation is the annual deduction that lets an owner recover the cost of a building over a fixed period set by statute. It reduces taxable income without reducing cash flow, which is why after-tax returns on real estate exceed pre-tax returns more often than in most asset classes.
- Cost segregation and bonus depreciationA cost segregation study reclassifies parts of a building into shorter-lived asset categories, typically five, seven and fifteen year property. Bonus depreciation then allows a percentage of that reclassified basis to be deducted immediately rather than over the shorter schedule.
- Equity multipleThe equity multiple is total distributions divided by total equity contributed, expressed as a multiple. A 2.0x means an investor received two dollars back for every dollar put in, counting the original dollar.
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