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Lesser Known 1031 Exchanges
In the world of 1031 Exchanges, there are a multitude of circumstances that investors find themselves in with property. While traditional, forward 1031 Exchanges are the most common, situations vary to which more nuanced forms of exchanges may need to be deployed. This blog will cover three types of 1031 exchanges that are not as well-known, including, Partial, Multi-Property, and Improvement Exchanges.
Partial 1031 Exchange
What is a Partial 1031 Exchange? Can you do a partial 1031 Exchange? Also known as a split exchange, a partial 1031 Exchange allows the property owner to exchange a portion of the sales proceeds from their Relinquished Property, and keep a portion for themselves, resulting in a partially tax deferred transaction. It is important to understand that tax will need to be paid on any money that is not reinvested into the Replacement Property. For example, if the Relinquished Property was sold for $1 million and the property owner only wants to reinvest $700,000 in a Replacement Property and pocket the $300,000 for a partial 1031 Exchange, they may do so. In keeping the cash, capital gains and other taxes will need to be paid on the $300,000. The $300,000 leftover, un-invested funds are known as “boot”.
Some common reasons property owners may want to utilize a partial 1031 Exchange include:
Pay down debt with proceeds
Cannot find desired Replacement Property that is equal in value
Use additional equity for non-real estate purchases such as inventory or equipment
Charitable contributions
While the term may be deceiving, a partial 1031 Exchange is not truly partial, it is indeed a fully executed 1031 exchange utilizing only a portion of the Exchange Funds, thereby giving it its name. Additionally, the tax deferral for a partial exchange is just that, partial, because as mentioned above any Exchange Funds not reinvested into qualifying Replacement Property will create a taxable event for the Exchanger.
Multiple Property Exchange
Can you exchange multiple properties into one property? Can you exchange one property into multiple properties? Yes, and yes. A 1031 Exchange with multiple properties, otherwise known as a Multi-Property Exchange, allows property owners to complete an exchange involving multiple properties. They can exchange one property for multiple Replacement Properties or relinquish multiple properties and exchange for a single property or exchange multiple relinquished properties for multiple replacement properties. 1031 Exchanges involving multiple properties can be a beneficial move for Exchangers looking to diversify their portfolios.
There has been a rise in Multi-Property Exchanges in states with significant appreciation in real estate values, such as New York, Hawaii, and California. For example, the median listing price of a property in San Diego County was approximately $650,000 in 2016 and reached roughly $1,000,000 in February 2024. In just 8 years, this represents a 54% gain. To defer capital gains tax and increase future profits, an investor who bought a property in 2016 for $650,000 and now has a million-dollar valuation on that property can identify two rental properties in Oregon, which has an average median home price of $502,000, that equate to the $1,000,000 sale of the original property.
Multi-Property Exchanges have gained popularity because investing in multiple properties, provides risk mitigation since all capital isn’t invested into one property, i.e., having all of your eggs in one basket.
Considerations for Identification in a Multi-Property Exchange
There are three rules that must be considered when identifying replacement property in a 1031 exchange, though the exchange only needs to satisfy one of the rules for a successful exchange. When considering Multi-Property Exchanges, the guidelines of these rules become more poignant:
3 Property Rule: Under IRC Section 1031, investors are allowed to identify up to 3 Replacement Properties. Not all properties have to be purchased, but they must be identified within the 45-day identification period.
200% Rule: Under this rule, investors are allowed to identify more than three3 Replacement Properties if their aggregate value does not exceed 200% of the sales price of the Relinquished Property.
95% Rule: Under this rule, if investors identify more than three3 Replacement Properties with a combined value of over 200% of the Relinquished Property value, the investor must close on at least 95% of the fair market value of those identified properties.
Improvement Exchange
Can you make improvements to property as part of a 1031 Exchange? Yes, with an Improvement Exchange a property owner can utilize proceeds from the sale of the Relinquished Property and use them to make improvements on the Replacement Property. This is usually done when the Replacement Property purchased is of lesser value than the Relinquished Property. Improvements can range from minor repairs or replacements to full-scale construction. Because this is a 1031 Exchange, improvements must be made within the 180-day period, or else any other improvements outside of the timeline could be subjected to taxation, which includes paid labor and materials.
For example, an owner of a commercial property bought the property for $400,000 a few years ago. The same property has appreciated in value and is now worth $1.4 million. The investor decides to sell their property and use the proceeds from that sale to buy another commercial property that needs some improvement. The cost of this new property is $1 million. Opting to not pay taxes on the $400,000 remaining proceeds from the sale of the first property, the investor chooses a 1031 Improvement Exchange, which will allow them to utilize the $400,000 for improvements such as installing central air, new flooring, and repairing the water heater. If the investor can meet all the standard requirements of a 1031 exchange, then they won’t have to pay taxes on the $400,000 until the property is sold.
When utilizing an Improvement Exchange, it is paramount to utilize a seasoned Qualified Intermediary to handle the complexities and requirements of this exchange to defer tax and ensure timelines and documents are in order.
A 1031 Exchange is not one size fits all; there are many options and types of exchanges that property owners can utilize to fit the needs of their particular transaction and investment goals. For 1031 exchanges that involve multiple properties, cash liquidation, or improvements, a 1031 exchange is still possible.
If you have any additional questions about the discussed exchanges or are looking to start one, please reach out to us at (800) 237-1031, email us at info@accruit.com, or live chat with us on our website.
The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.
