Navigating a 1031 exchange can be complex due to the specific terminology and requirements involved. Whether you’re just starting to learn about 1031 exchanges or need a refresher on some key terms, understanding the essential language is crucial for a smooth transaction. In this blog, we’ll break down some of the most important 1031 exchange terms that every taxpayer should know.

Exchanger/Taxpayer: The official party responsible for completing a 1031 exchange. This party owns the qualifying real estate being relinquished (sold) and acquires the replacement property with the use of a third party, or “Qualified Intermediary”.

Relinquished Property: The property the taxpayer sells, or “trades in” for a new property in the exchange. 

Replacement Property: The property the taxpayer acquires using sale proceeds from their sale in their 1031 exchange. 

Safe Harbor / Non-Safe Harbor: 

A safe harbor exchange is a 1031 exchange that maintains compliance with the regulations established by the Internal Revenue Code. Meeting such guidelines, further clarified in 1991, ensures the exchange qualifies and is considered valid. There are four “safe harbors”, including:

• Security or Guarantees
• Qualified Escrow or Trusts
• Qualified Intermediary 
• Interest or Growth Factors

A non-safe harbor exchange steps outside of the safe harbor regulations and will not provide the taxpayer a guaranteed, valid exchange. In short, this type of exchange relies more on case studies to prove why the exchange in review should be valid instead of meeting the requirements on the front end.

Non-safe Harbor exchanges may have more flexibility but also come with a higher risk and less certainty compared to a safe harbor or “Green Light” 1031 exchange.

Tax-Deferred Exchange: This is another term for a 1031 exchange. 1031 exchanges are commonly referred to as a “Tax-Deferred Exchange”, “Like-Kind Exchange” or “Delayed Exchange”. A 1031 exchange is intended to successfully defer taxes, not avoid them. The only time taxes are fully avoided is when the taxpayer or exchanging party passes at which point the taxpayer’s heir(s) take on the property with a step-up in basis.

Like-Kind Property: One of the many requirements for a compliant 1031 exchange is that both the relinquished and replacement property are considered like-kind. The “Like-Kind” criteria does not mean that the sale and purchase property are used for the same specific purpose but that the use of both properties are held long-term with business or investment intent.

Section 1031/ Internal Revenue Code: Section 1031 is the section of the tax code that provides the taxpayer the ability to complete a 1031 exchange as well as the guidelines for a 1031 exchange. When using a qualified intermediary (QI), the QI is morally responsible to abide by this tax code. It is crucial to be clear about your intent with your QI, so they have the opportunity to properly discuss all aspects of your potential 1031 exchange. More importantly, be sure to consult your CPA/Tax Advisor.

1031 Exchange: Property owners of qualified real estate are allowed to sell their property without paying taxes on the gain so long as they reinvest the sale proceeds or, exchange value, into like-kind property held long-term for business or investment use.

Qualified Intermediary: A qualified intermediary is simply a third party that is not disqualified to facilitate a 1031 exchange. Most people can act as your qualified intermediary outside of:

A related party of the exchanger and cannot be an agent of the Exchanger.

This includes an employee, attorney, accountant, investment banker, real estate agent or broker of the exchanger within the last two years.

There are no federal regulations for 1031 exchange qualified intermediaries or licensing requirements. Additionally, a qualified intermediary is not supervised by a government entity. That being said, there are eight of the fifty that regulate qualified intermediaries at the state-level. These states are New Hampshire, Virginia, Washington, Nevada, Idaho, Colorado, California, and Maine.

Constructive / Actual Receipt: To achieve tax deferral, the qualified intermediary receives funds instead of the taxpayer. One of the many ways to invalidate a 1031 exchange is to directly or indirectly receive the sale proceeds from the relinquished property. Any residual funds leftover at the end of a 1031 exchange are allowed to be disbursed to the taxpayer and subject to tax.

3 Property Rule: This is the first of three identification rules. The three property rule allows for an exchanger to identify up to three properties without regard to the fair market value of those properties.

200% Rule: If you exceed the three property rule and identify more than three properties then the value of those properties should not exceed double the value of the sale.

95% Rule: If the taxpayer identifies more than three properties and the value of those properties exceeds double the value of the sale then the exchanger agrees to purchase 95% of the value of the identified properties.

Original Basis: A taxpayer’s original basis is the price the property being relinquished  was originally acquired for.

Adjusted Basis: This is the taxpayer’s original basis with regards to improvements, depreciation or deductions and other modifications made or taken over time.

Stepped Up Basis: If a taxpayer who owns property acquired through a 1031 exchange passes away, their heir(s) may receive a “step-up” in basis. This means the property’s basis is adjusted to its fair market value on the date of the original owner’s death. As a result, the heir(s) are not required to pay the deferred capital gains taxes on the property, as the tax liability is effectively reset based on the new, stepped-up value.

Exchange Period: For a safe harbor exchange, the taxpayer has 180 days to complete their 1031 exchange. This window is triggered by the day of closing on their first relinquished property. The taxpayer has the first 45 days of those 180 days to identify replacement property and once that window ends, has 135 days to close. If the taxpayer identifies prior to day 45, he/she has until the end of day 45 to revoke and/or edit their original designation.

It is important to note that taxpayers do not have to wait until after the 45 day window ends to close on replacement property. Once the identification window ends, the exchanging party cannot alter their identified properties. Exchangers/taxpayers do have the option to not identify replacement property in which their exchange would close on day 46 and funds would be disbursed to them.

Capital Gain: Capital gain is the profit produced from the sale of assets and in this case, the sale of real estate. Capital gain is considered taxable income per the Internal Revenue Service. At the state level, depending on the state, this could be up to 13.3% or 15 to 20% at the federal level and is subject to deferment with the use of a 1031 exchange. For more information on the potential capital gain tax implications, see here.

Net Investment Income Tax:  The Net Investment Income Tax, or “NIIT”, subjects taxpayers with a modified adjusted gross income of $200,000 (for single filers) or $250,000 (for married filers) to an additional 3.8% tax and is a tax that can also be deferred with use of a 1031 exchange. For more information on the Net Investment Income Tax, see here.

Depreciation Recapture: This refers to a 25% tax that applies to the depreciation claimed on a depreciable asset during the period the taxpayer owned the asset. For more information on depreciation recapture, see here.

Taxable Boot: There are two different forms of boot related to a 1031 exchange. “Cash Boot”, which is when a taxpayer sells for $500,000, purchases for $250,000 and receives the difference at closing or after their exchange is completed. In this example, the taxpayer would be taxed on the difference received to their bank account.

“Mortgage Boot” is when there is debt associated with the relinquished property and the taxpayer opts to not replace it with either new debt or fresh equity. For example, Taxpayer A has a loan originally for $50,000 and ended up with a $40,000 loan, then this taxpayer has $10,000 in mortgage boot which is subject to capital gains tax even though the $10,000 was never received by the taxpayer in cash.

Understanding the key terms of a 1031 exchange is essential for a successful transaction. By familiarizing yourself with these concepts, you’ll be better prepared to navigate the process and ensure compliance. Be sure to consult with a CPA or tax advisor to ensure you’re making the best choices for your situation.

The information presented is for information purposes and is not intended as investment, legal, tax or compliance advice. Land 1031 does not offer or sell investments or provide investment, legal, or tax advice.

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