Are you looking to trade in an investment property for another one? If you are, a 1031 exchange is a powerful strategy that allows an investor to defer paying capital gains taxes on the sold property as long as that investor follows some specific rules and buys another ‘like-kind property.’ This post will deal with the different types of 1031 exchanges.
A simultaneous exchange is a 1031 exchange where the sold property and the replacement property are closed on the same day. It is not sufficient to wire proceeds from the sale closing to the purchase closing on the same day and obtain tax deferral. There are three specific ways this exchange can occur.1.) Swap or two-party trade. This involves two parties swapping deeds. Technically, this can be difficult to execute since both parties must want to swap deeds at exactly the same time.2.) Three-party exchange. This involves an ‘accommodating third party’ that serves to facilitate the exchange and to ensure it is done in a simultaneous fashion. The title can pass through the buyer or through the seller. 3.) Simultaneous exchange with a qualified intermediary (QI). This exchange involves a QI who structures the entire exchange including providing written instructions to the closing officers, and prepares the exchange agreement.
This type of 1031 exchange is the most common type and occurs when the exchanger relinquishes a property before acquiring another replacement property. Once an exchanger secures a buyer and executes a sale and purchase agreement, he or she can then hire a third-party exchange intermediary. The intermediary initiates the sale of the property and holds the proceeds from the sale in a binding trust (for up to 180 days.) The investor has 45 days to identify the replacement property and 180 days to complete the sale of the relinquished property.
A reverse exchange is one where the exchanger purchases the replacement property before selling the relinquished property. Since the investor can not simultaneously hold the titles of both the replacement and relinquished properties, an exchange accommodation titleholder (EAT) is utilized. The EAT temporarily holds, or “parks,” the title to one of the properties. Reverse exchanges must still follow the same 45-day and 180-day time limits as a delayed exchange.
A construction exchange is one where the investor is able to make improvements on the replacement property, using the exchange equity and thereby defer capital gains tax. The requirements that dictate this exchange are: 1.) The entire exchange equity must be spent on completed improvements or as a down payment by the 180th day. 2.) The investor must receive ‘substantially the same property’ that they identified by the 45th day. 3.) The replacement property must be equal or greater in value when it is deeded back to the investor. A qualified intermediary holds the title until the improvements are completed.