1031 Exchange Basics for Texas Real Estate Investors

A Section 1031 exchange lets an investor sell business or investment real estate and buy replacement property while deferring the federal tax on the gain. Used well, it lets you trade up from a small rental to a larger commercial building, consolidate several properties into one, or move from raw land into income property without losing part of your equity to taxes along the way. The rules are strict, though, and missing a deadline by one day can make the entire gain taxable. Here are the basics, drawn from IRS guidance.

What qualifies

Since 2018, like-kind exchange treatment applies only to real property held for use in a trade or business or for investment. Equipment, vehicles and other personal property no longer qualify. Real property held primarily for sale (such as lots a developer builds and sells, or a house bought to flip) doesn’t qualify either, and neither does your personal residence.

“Like-kind” is broad for real estate. According to the IRS’s fact sheet on like-kind exchanges, both properties must be held for business or investment use, and real property is generally like-kind to other real property. That means you can exchange, for example:

• Timberland in Hardin County for a retail strip center in Beaumont
• A rental house for a warehouse
• An office building for raw land held for investment

U.S. real property and foreign real property are not like-kind.

The two deadlines

Most exchanges are “deferred” exchanges: you sell first, then buy. The IRS fact sheet sets out two time limits that cannot be extended for any circumstance or hardship, except in the case of presidentially declared disasters:

1. 45-day identification period. Within 45 days of selling your relinquished property, you must identify potential replacement properties in writing, signed by you and delivered to a person involved in the exchange, such as the seller of the replacement property or your qualified intermediary. Notice to your own attorney, real estate agent or accountant is not sufficient. Real estate must be clearly described by legal description, street address or a distinguishable name.
2. 180-day exchange period. You must receive the replacement property and complete the exchange within 180 days after the sale or by the due date (with extensions) of your tax return for the year of the sale, whichever is earlier. The property you buy must be substantially the same as what you identified.

The second deadline catches people who sell late in the year. If you sell in November and file your return on April 15 without an extension, your exchange period could end before the full 180 days. Talk to your CPA about filing an extension.

How many properties can you identify?

The Treasury regulations (26 CFR 1.1031(k)-1) limit identification. In general, you may identify up to three properties of any value, or any number of properties as long as their total value doesn’t exceed 200% of the value of the property you sold. There are exceptions and details here; your intermediary and tax advisor should confirm your identification is valid.

Use a qualified intermediary

If you receive the sale proceeds, even briefly, the exchange generally fails. Most investors use a qualified intermediary (QI), sometimes called an accommodator, who holds the proceeds and uses them to buy the replacement property. Set up the exchange agreement with the QI before you close the sale. Your own agent, attorney or accountant who has worked for you recently usually can’t serve as your QI.

Choose a QI carefully. QIs hold large sums of client money, so ask about bonding, insurance and how funds are held.

Boot: what’s taxable

To defer all the gain, you generally need to buy replacement property of equal or greater value and reinvest all the net proceeds. Anything you receive that isn’t like-kind property, such as cash left over, or a reduction in mortgage debt that isn’t offset, is called “boot” and is taxable up to the amount of your gain. A common mistake is paying off a large loan on the old property and taking on a smaller loan on the new one without adding cash to make up the difference.

Other variations

• Reverse exchange. You buy the replacement property first. The IRS fact sheet describes this as more complex: the property is held by an exchange accommodation titleholder for no more than 180 days while you sell the relinquished property.
• Improvement (build-to-suit) exchange. Exchange funds pay for improvements to the replacement property, but only improvements completed within the 180-day period count.
• Related parties. Exchanges with family members or related entities have special rules, including a two-year holding requirement. The IRS requires Form 8824 to be filed for the two years following a related-party exchange.

Reporting

You report an exchange on IRS Form 8824 with your tax return for the year of the exchange. The form asks for descriptions of the properties, the dates they were identified and transferred, any relationship between the parties, and the values and gain involved.

The deferral isn’t forgiveness

A 1031 exchange defers tax; it doesn’t eliminate it. Your basis in the old property carries over to the new one, so when you eventually sell without exchanging, the deferred gain plus any new gain is taxable. Investors often exchange several times over a lifetime. The tax treatment at death is a separate question for your estate planner.

Practical tips for Southeast Texas investors

• Start looking before you sell. Forty-five days goes fast, especially in a smaller market like Beaumont–Port Arthur, where good commercial properties don’t come up every week. Have candidates in mind before listing your property.
• Identify backups. If your first choice falls through in due diligence, a backup on your identification list can save the exchange.
• Allow time for due diligence. Flood zone checks, surveys, environmental reports and lender approvals all take time. Make sure your contract timelines fit inside the 180 days.
• Coordinate early. Your CPA, QI, title company and broker should all know from the start that the sale is part of an exchange.

If you’re planning an exchange, we can help you line up replacement properties before your sale closes. Browse current listings or contact us to talk through what you’re looking for.

This article is general information, not legal or tax advice. 1031 exchanges have technical requirements; consult a qualified tax advisor and qualified intermediary before selling.