1031 Exchange – Concepts and Terms

1031 Exchange – Concepts and Terms

Welcome to our comprehensive list of concepts and terms common to the 1031 Tax-Deferred Exchange. This resource is crafted to help professionals, investors, and others understand the terms used as part of a 1031 exchange in real estate.

The 1031 exchange, rooted in Section 1031 of the Internal Revenue Code, offers investors the opportunity to defer capital gains taxes on the exchange of like-kind properties, making it a pivotal strategy in real estate investment and financial planning. The terms in this guide cover a wide spectrum, from basic concepts like ‘Basis’ and ‘Boot’ to more complex topics such as ‘Reverse Exchange’ and ‘Improvement Exchange’.

By providing clear definitions and explanations, this list aims to demystify the technical language of 1031 exchanges, making it accessible for both novices and seasoned professionals in the field. Whether you’re engaging in your first 1031 exchange or are a veteran looking to refresh your knowledge, this list will be an indispensable reference in your journey through the world of real estate investment.

1031 Exchange: Concepts and Terms

1031 Exchange: A section of the U.S. Internal Revenue Code that permits deferral of capital gains taxes on the exchange of like-kind properties. It’s used primarily in real estate but can apply to certain personal property exchanges.

200% Rule: A rule in a 1031 exchange that allows an investor to identify any number of potential replacement properties, as long as their combined fair market value does not exceed 200% of the total fair market value of all relinquished properties.

95% Rule: This rule allows an investor to identify more than three properties as potential replacements, regardless of their total value, provided that the investor acquires at least 95% of the aggregate value of all identified properties.

Accommodator: Also known as a Qualified Intermediary, this is an independent party who facilitates the 1031 exchange process by holding the sale proceeds from the relinquished property and using them to acquire the replacement property.

Accelerated Cost Recovery System (ACRS): A depreciation method used for property placed in service between 1981 and 1986, allowing for faster depreciation than previous methods. For assets put in service after 1986, the Modified Accelerated Cost Recovery System (MACRS) took its place.

Accelerated Depreciation: A method of depreciation where a larger portion of an asset’s cost is written off in the early years, compared to the straight-line method that spreads the cost evenly over the asset’s life.

Actual Receipt: In a 1031 exchange, this occurs when the taxpayer physically or constructively receives funds or property from the sale of the relinquished property, potentially disqualifying the exchange.

Adjusted Cost Basis: The original cost of a property plus capital improvements, less any depreciation, casualty losses, or other reductions. This value is used to determine capital gains or losses upon sale.

After-Tax Return: The return on an investment after accounting for taxes. This figure provides a more accurate picture of an investment’s profitability by including tax liabilities.

Agent: An individual or entity that acts on behalf of another. In the context of 1031 exchanges, agents such as accountants or attorneys cannot be Qualified Intermediaries if they have served the taxpayer in their professional capacity within the last two years.

Alternative Minimum Tax (AMT): A parallel tax system designed to ensure that individuals, corporations, trusts, and estates that benefit from certain exclusions, deductions, or credits pay at least a minimum amount of tax.

Asset: Any property owned by an individual or business that has economic value or can provide future benefits. In real estate, this typically refers to properties or land.

Asset Allocation: The process of distributing investments among various types of assets (e.g., stocks, bonds, real estate) to balance risk and reward according to an individual’s goals, risk tolerance, and investment horizon.

Asset Class: A group of securities or investments that exhibit similar characteristics and behave similarly in the marketplace. Common asset classes include stocks, bonds, and real estate.

Balancing the Exchange: Ensuring that the values, equity, and debt between the relinquished and replacement properties in a 1031 exchange are balanced, to fully defer capital gains taxes.

Basis: The financial interest an investor has in an asset, typically the purchase price plus any improvements and less any depreciation. It is used to calculate gains or losses for tax purposes upon sale.

Beneficiary: An individual, entity, or trust that receives benefits from a will, trust, retirement plan, or insurance policy.

Bond: A fixed-income instrument representing a loan made by an investor to a borrower, typically corporate or governmental. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations.

Boot: In a 1031 exchange, it refers to any additional value received in the exchange that is not like-kind property, such as cash or debt relief. Boot is typically taxable to the recipient.

Build-to-Suit Exchange: A type of 1031 exchange allowing improvements on a replacement property using exchange proceeds before the property is formally acquired.

Business Assets: Tangible and intangible items owned by a business and used in its operations. These can include real estate, equipment, patents, and trademarks.

Capital Gain or Loss: The difference between the selling price of an asset and its basis. A gain occurs if the asset sells for more than its basis; a loss occurs if it sells for less.

Capital Gain Tax: A tax on the profit realized from the sale of a non-inventory asset that was purchased at a cost amount that was lower than the amount realized on the sale.

Capital Improvements: Permanent structural changes or restorations to a property that enhance its property value, extend its useful life, or adapt it to new uses.

Capitalization Rate: A rate of return on a real estate investment property based on the expected income that the property will generate, used to estimate the investor’s potential return on investment.

Cash Equivalents: Short-term, highly liquid investments that are readily convertible to known amounts of cash and so near their maturity that they present insignificant risk of changes in value due to changes in interest rates.

Charitable Lead Trust: A trust that provides a fixed amount or percentage of the trust’s assets to a charity for a specified period, after which the remaining assets pass to non-charitable beneficiaries, such as family members.

Charitable Remainder Trust: A trust that provides an income stream to the donor or other beneficiaries for a period, after which the remaining assets are donated to a charity.

Collectibles: Personal property items such as artwork, antiques, coins, stamps, and other valuable collectibles. These are often considered for investment purposes.

Community Property: A form of ownership by married couples recognized in some states where all assets acquired during the marriage are considered equally owned by both spouses.

Concurrent Exchange: A type of 1031 exchange where the relinquishment of the sold property and acquisition of the new property occur simultaneously.

Condominium: A form of property ownership where each owner holds title to a unit within a larger building or complex, along with a shared interest in common areas.

Constructive Receipt: A tax term indicating that a taxpayer is considered to have received income or assets, even if not in actual possession, thus triggering tax implications.

Cooperation Clause: A provision in real estate contracts indicating the seller’s and buyer’s agreement to cooperate in a 1031 exchange, which can be crucial for its successful completion.

Cooperatives (Co-ops): A type of residential or business property ownership where each member owns shares in a cooperative corporation, which in turn owns the property.

Corporation: A legal entity that is separate and distinct from its owners, offers limited liability to its shareholders, and has its own rights and responsibilities.

Deduction: An expense subtracted from gross income for tax purposes. Deductions reduce taxable income and are a factor in calculating a taxpayer’s liability.

Deferred Exchange: Another term for a 1031 exchange is that the capital gains tax on the exchange of like-kind properties is deferred.

Delayed Exchange: A common type of 1031 exchange where there is a time gap between the sale of the relinquished property and the acquisition of the replacement property.

Depreciable Property: Property eligible for depreciation for tax purposes is generally an asset that has a useful life of more than one year and is used in a business or for income generation.

Depreciation: An accounting method of allocating the cost of a tangible asset over its useful life, representing wear and tear, decay, or decline in value.

Depreciation Recapture: A tax provision where the IRS collects taxes on the sale of a depreciable asset, recapturing some or all of the depreciation deductions previously taken.

Direct Deeding: A process in a 1031 exchange where the relinquished property is deeded directly from the seller to the buyer and the replacement property is deeded from the seller to the buyer, bypassing the Qualified Intermediary.

Disposition: The act of selling or otherwise disposing of an asset or property.

Dividend: A distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders.

DST (Delaware Statutory Trust): A legal entity created under Delaware law that allows for fractional ownership of real estate and is used in 1031 exchanges.

EAT (Exchange Accommodation Titleholder): An entity used in reverse and improvement exchanges to hold title to either the relinquished or replacement property temporarily.

Equity: The value of an owner’s interest in a property, calculated as the property’s market value minus any liabilities such as mortgages or liens.

Exchange: In a 1031 context, it refers to the process of deferring capital gain tax by exchanging one investment property for another like-kind property.

Exchange Accommodation Titleholder (EAT): An entity that holds legal title to the property in a reverse or improvement 1031 exchange.

Exchange Agreement: The contractual agreement between the taxpayer (Exchanger) and the Qualified Intermediary, outlining the terms and conditions of the 1031 exchange.

Exchange Period: The period within which the new property must be acquired in a 1031 exchange, which is a maximum of 180 days from the date of transfer of the first relinquished property.

Exchanger: The individual or entity carrying out a 1031 exchange.

Excluded Property: Property that does not qualify for a 1031 exchange, such as the taxpayer’s primary residence, stocks, bonds, or inventory.

Fair Market Value: The estimated market value of a property based on what a knowledgeable, willing, and unpressured buyer would likely pay to a knowledgeable, willing, and unpressured seller in the market.

Fixed Income: A type of investment security that pays investors fixed interest or dividend payments until its maturity date, after which the principal amount is repaid.

Fractional Interest: Partial interest in a property where multiple parties share ownership but no single owner has exclusive rights to the entire property.

Going Concern Value: The additional value of a business entity compared to just the value of its assets, considering its established operations and income potential.

Goodwill: An intangible asset representing the value of a business entity over and above its physical assets and liabilities, often related to reputation, customer loyalty, or brand value.

Gross Multiplier: A simple financial metric used in the income approach to real estate valuation, calculated by dividing the sale price of a property by its gross rental income.

Identification Period: The 45-day period after the sale of the relinquished property during which the taxpayer must identify potential replacement properties in a 1031 exchange.

Improvement Exchange: A type of 1031 exchange where the taxpayer can use exchange funds to improve the replacement property before taking title to it.

Improvements: Permanent enhancements made to a property that increase its value, prolong its life, or adapt it for new uses. In real estate, this includes additions to buildings or other structures.

Income Tax: A tax levied by the government directly on income, especially an annual tax on personal income.

Intangible Personal Property: Non-physical assets such as stocks, bonds, patents, copyrights, and trademarks.

Intermediary: Also known as a Qualified Intermediary, this neutral third party facilitates the process of a 1031 exchange by holding funds and ensuring the transaction adheres to IRS rules.

Internal Revenue Code 1031: A section of the U.S. Internal Revenue Code that allows for the deferral of capital gains taxes on the exchange of like-kind properties.

Irrevocable Trust: A trust that cannot be modified or terminated without the permission of the beneficiary. Once a grantor transfers assets into the irrevocable trust, they remove their rights of ownership to the assets and the trust.

I.R.S.: Internal Revenue Service, the U.S. government agency responsible for tax collection and tax law enforcement.

Joint Tenancy: A form of legal co-ownership of property where property transfers to the other owners upon the death of one owner.

Like-Class and Like-Kind Personal Property: Refers to the nature or character of personal property exchanged in a 1031 exchange. Properties must be similar in nature or character, even if they differ in grade or quality.

Like-Kind Exchange: A real estate transaction under IRC Section 1031 where a property is exchanged for another property of ‘like-kind’ to defer capital gains taxes.

Like-Kind Property: In a 1031 exchange, properties exchanged must be of similar nature, character, or class, regardless of grade or quality.

Limited Liability Company (LLC): A business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation.

Limited Partnership: A partnership where at least one partner has unlimited liability and other partners have limited liability.

Living Trusts: A trust established during a person’s lifetime in which a person’s assets are placed within the trust, and the income generated is paid to the trustor, during their lifetime.

Mixed Property (Multi-Asset) Exchange: In a 1031 exchange, this refers to the exchange of multiple assets, which could include a mix of real estate, personal property, and other investment types.

Modified Accelerated Cost Recovery System (MACRS): The current tax depreciation system in the United States. This system allows the capitalized cost (basis) of tangible property to be recovered over a specified life by annual deductions for depreciation.

mortgage Boot/Relief: Occurs when a mortgage or debt on the replacement property is less than the mortgage on the relinquished property. This difference is treated as income or ‘boot’ and can be taxable.

Multiple Property Exchange: In a 1031 exchange, this refers to exchanging one or more properties for several other properties.

Napkin Test: An informal method to estimate whether a 1031 exchange will be completely tax-free by comparing the value, equity, and debt of the relinquished and replacement properties.

Net Operating Income (NOI): A calculation used to analyze real estate investments that determines the property’s income after operating expenses are deducted.

Ordinary Income Tax: Tax imposed on an individual’s or entity’s income from sources other than capital gains, such as wages, salaries, and interest.

Parking Arrangement: In a reverse 1031 exchange, the replacement property is ‘parked’ with an Exchange Accommodation Titleholder before the relinquished property is sold.

Partial Exchange: A 1031 exchange where the taxpayer receives some taxable ‘boot,’ resulting in a transaction that is partially taxable and partially tax-deferred.

Partial Tax Deferment: This occurs when only a portion of the capital gain is deferred in a 1031 exchange and the rest is taxed as regular income.

Partnership (tenancy in partnership): an association of two or more persons to carry on as co-owners of a business for profit.

Personal Property Exchange: This involves exchanging personal property (such as machinery, equipment, or vehicles) that is held for business or investment purposes.

Principal Residence Exemption: Under IRC Section 121, this allows for exclusion from capital gains tax on the sale of a primary residence, up to certain limits.

Qualified Escrow Account: An account where the funds from the sale of the relinquished property in a 1031 exchange are held to prevent actual or constructive receipt by the exchanger.

Qualified Exchange Accommodation Arrangement: An arrangement that allows for a reverse 1031 exchange, where the replacement property is acquired before selling the relinquished property.

Qualified Exchange Accommodation Agreement: The agreement that structures a reverse 1031 exchange under Revenue Procedure 2000-37.

Qualified Intermediary: A neutral third party who facilitates a 1031 exchange by holding proceeds from the sale of the relinquished property and then using them to acquire the replacement property.

Qualified Trust Account: Similar to a qualified escrow account, it’s an account where the funds from a 1031 exchange are held to avoid actual or constructive receipt by the exchanger.

Qualified Use: In a 1031 exchange, this refers to the requirement that both the relinquished and replacement properties must be held for investment or used in a trade or business.

Real Property: Land and generally anything erected, growing, or affixed to the land.

Real Estate Investment Trust (REIT): A company that owns, operates, or finances income-producing real estate and allows investors to buy shares in commercial real estate portfolios.

Real Property Exchange: The process of exchanging one piece of real estate for another without the immediate recognition of capital gains taxes, under IRC Section 1031.

Related Party: In a 1031 exchange, parties who have a familial or business relationship, where special rules apply to prevent abuse of tax deferral benefits,.

Relinquished Property: The property that an investor gives up in a 1031 exchange.

Replacement Property: The new property acquired in a 1031 exchange.

Reverse Exchange: A 1031 exchange where the replacement property is acquired before the relinquished property is sold.

Reverse/Improvement Exchange: A 1031 exchange that enables improvements on the replacement property before the exchanger acquires it.

Revocable Trust: A trust that can be altered or canceled by the trustor.

Rollover: The process of moving funds from one retirement plan to another without incurring tax consequences.

Roth IRA: a retirement account allowing a person to set aside after-tax income up to a specified amount each year. Earnings on the account can be tax-free.

S Corporation: A form of corporation that meets specific Internal Revenue Code requirements, giving it a pass-through taxation status.

Safe Harbors: Provisions in the tax code that provide protection from penalties, provided specific conditions are met.

Seller Carry-Back Financing: A type of financing where the seller of the property provides financing to the buyer, which can be used in certain 1031 exchanges.

Sequential Deeding: In a 1031 exchange, this is the process where the property is first transferred to the Qualified Intermediary and then from them to the end buyer.

Simultaneous Exchange: A 1031 exchange where the relinquished and replacement properties are exchanged at the same time.

Starker Exchange: Another term for a delayed or deferred 1031 exchange, named after the Starker court case.

Straight-Line Depreciation Method: A method of depreciation where the value of an asset is reduced uniformly over its useful life.

Tangible Personal Property: physical property such as machinery, equipment, vehicles, and furniture, as opposed to intangible property like stocks and bonds.

Tax-deferral: the postponement of taxes to a future period, often utilized in retirement plans and 1031 exchanges.

Tax-Deferred Exchange: Another term for a 1031 exchange where capital gains taxes on the exchange of like-kind property are deferred.

Taxpayer: The individual or entity that is responsible for paying taxes to a governmental authority.

Tenancy-In-Common Interest (Co-Tenancy): A form of co-ownership where each party owns a separate and undivided interest in the property.

Tenancy in Severalty: Ownership of property by one person or entity exclusively.

Titleholder: The person or entity who has legal ownership and right to the property.

Trust: A legal arrangement where one party holds property for the benefit of another party.

Trustee: The person or entity that holds and manages property or assets for the benefit of a third party in a trust.