Key terms to understand when embarking on your first 1031 exchange.
When researching Section 1031 like-kind exchanges, you may feel overwhelmed by the immense amount of new terminology. If you come across a phrase you are unfamiliar with, search for it in this guide, which contains helpful links to pages explaining important concepts in detail.
45-Day Identification Deadline: in a forward exchange, potential replacement properties must be identified in writing within 45 days from the date the relinquished property is sold. In a reverse exchange, relinquished properties must be identified within 45 days from the date the EAT takes title of the property. Learn more about identification rules here.
95% Rule: the 95% rule is a 1031 identification rule that allows the exchanger to identify any number of properties with an unlimited aggregate fair market value provided the exchanger acquires at least 95% of the aggregate fair market value of all properties identified.
180-Day Deadline: in a forward exchange, the exchange must be completed within 180 days from the date of sale of the relinquished property. In a reverse exchange, the exchanger has 180 days from the date the EAT parks the property to complete the exchange. An exception is when the due date (including extensions) of the taxpayer’s tax return for the year in which the relinquished property was sold comes before 180 days, in which case the tax return due date is the deadline.
200% Rule: the 200% rule is a 1031 identification rule that states any number of properties can be identified provided their aggregate fair market value does not exceed 200% of the value of the relinquished property(ies). Learn more about the 200% rule here.
721 upREIT: Section 721 of the Internal Revenue Code allows for tax deferral when property is contributed to a partnership in exchange for an interest in the operating partnership. An Umbrella Partnership Real Estate Investment Trust (upREIT) provides a way to go from whole property ownership to a REIT while continuing tax deferral. Learn more about this process here.
1031 Exchange: §1031 of the Internal Revenue Code allows for the deferral of capital gains taxes on the sale of business or investment property that is exchanged for like-kind property. For more information, read our 1031 Exchange Guide.
Actual receipt: when an exchanger takes control of sales proceeds, they are said to have taken actual receipt of funds. If an exchanger takes actual receipt of proceeds from the sale of the relinquished property before the replacement property is acquired, the exchange will be considered invalid under Section 1031. To avoid actual receipt, a Qualified Intermediary is necessary.
Adjusted Basis: the adjusted basis of a property is calculated by adding the purchase price and any capital improvements, and then subtracting depreciation. It should be noted that certain transactions such as exchanges, gifts, probates, and trust distributions may have an impact on the adjusted basis of the property. In order to determine the correct adjusted basis for tax purposes, consult with an experienced tax and legal advisor.
Basis: the initial purchase price of a property, used in calculating the taxable gain. If a property acquired in a 1031 exchange is subsequently sold in a taxable sale, the original purchase price of the first property relinquished in the original exchange is used as the basis for calculating gains.
Boot: any non-like-kind property (cash, mortgage notes, stocks, boats, or other items) received in an exchange that is subject to taxation. Read our guide to 1031 exchange taxable boot here.
Business or Investment Property: any property held for “productive use in a trade or business or for investment” can potentially qualify under Section 1031 and be used as part of an exchange. For information about exceptions (like property held primarily for sale), read our 1031 Real Estate Guide.
Capital Gains Tax: a tax on the profit derived from the sale of property. A 1031 exchange allows taxpayers to defer federal capital gains taxes on property sales if a like-kind property is purchased according to Section 1031 rules.
Claw-Back Provision: certain states have tax code provisions that “claw back” state taxes that have been deferred in a 1031 exchange. If a property located in one of these states is used as a relinquished property for a state-to-state exchange, yearly filing may be required so long as a taxable sale has not been executed, at which time the clawback kicks in and state taxes are assessed. Read more about claw-back provisions and which states have them here.
Constructive Receipt: similar to actual receipt, constructive receipt is the ability of an exchanger to control proceeds even in the absence of funds being physically in their possession. A Qualified Intermediary is necessary to avoid taking constructive receipt or control of sales proceeds.
Deferred or Delayed Exchange: other terms for a forward exchange.
Delaware Statutory Trust (DST): a type of real estate investment in which a group of investors pools funds to purchase a property or series of properties overseen by a professional property manager. DSTs are popular replacement properties in 1031 exchanges. Learn more about DSTs here.
Depreciation Recapture: taxes due on gains from the sale of depreciable assets. Depreciation recapture requires taxpayers to adjust their realized gains based on previously-reported depreciation deductions. A Section 1031 like-kind exchange can allow taxpayers to defer depreciation recapture until a property is sold in a taxable sale.
Direct Deeding: as opposed to sequential deeding, direct deeding of a property is where the seller deeds the property directly to the buyer after executing all requisite exchange documents.
Drop and Swap: a method by which a partnership distributes a fractional interest to one or more of its partners, who can then sell or exchange their individual interest. Learn more about LLCs and other 1031 ownership structures here.
Exchange Accommodation Titleholder (EAT): in a reverse exchange, the Exchange Accommodation Titleholder is a third-party special-purpose entity that acquires title to a property and parks it according to IRS safe harbor rules. Learn more about JTC’s reverse exchange EAT services here.
Exchange Last: a type of reverse exchange in which the replacement property is acquired and parked by the EAT at the start of the exchange, followed by the sale of the relinquished property. To learn more, read our Reverse Exchange Guide.
Exchange First: a type of reverse exchange in which the relinquished property is sold to the EAT at fair market value, followed by the acquisition of the replacement property and the sale of the relinquished property by the EAT. To learn more, read our Reverse Exchange Guide.
Exchanger: the taxpayer executing the 1031 exchange. The taxpayer selling the relinquished property must be the same taxpayer acquiring the replacement property.
Fair Market Value: the estimated value of a property if it were sold on the open market. Determining the fair market value of a property is important when performing an Exchange First reverse exchange. Selling or acquiring a property at fair market value is also important to avoid the appearance of impropriety when conducting a related-party exchange.
Forward Exchange: the most common type of 1031 exchange involves the sale of a relinquished property followed by the acquisition of a replacement property. Learn more about forward exchanges here.
Improvement Exchange: a type of 1031 exchange in which some exchange funds are used to make improvements to the replacement property. Also known as a construction exchange or build-to-suit exchange. To better understand this type of exchange, watch this 1031 webinar.
IRC Section 121: allows for the exclusion of some gain on a taxpayers’ primary residence. You can learn about the differences between 121 and 1031, and how they can sometimes be used in tandem, by reading our blog.
Like-Kind Property: under U.S. tax law, all real estate properties located within the country are generally considered “like-kind,” meaning they have the same essential nature and character, regardless of their specific grade or quality. This allows real estate investors and business owners to exchange one U.S. property for another without incurring immediate tax liabilities, as long as the properties are held for investment or productive business use. Learn more about the definition of like-kind property here.
Mortgage Boot: occurs when the debt paid off at closing on the relinquished property exceeds the debt and/or cash contribution obtained on the replacement property. Read more about mortgage boot here.
Multi-Property Exchange: a 1031 exchange that involves more than one relinquished or replacement property. Read our guide to 1031 and real estate for more on exchanges with multiple properties.
Partial Exchange: an exchange where only a portion of the proceeds from the relinquished property sale are used to acquire the replacement property. The remaining portion returns to the taxpayer as taxable boot. This is also referred to as a split exchange.
Passive Income: income from an investment that does not require active management. In real estate, triple-net leases and Delaware Statutory Trusts can provide passive income.
Qualified Escrow Account: an account structure that stipulates rules for disbursement of funds. According to 1031 best practices, a Qualified Intermediary should hold exchange funds in a Qualified Escrow Account or Qualified Trust Account, with funds only released through dual authorization from the QI and exchanger.
Qualified Exchange Accommodation Agreement (QEAA): in a parking transaction, the exchanger must enter into an agreement with the EAT known as a QEAA within five days of the EAT taking title of the parked property. Learn more about JTC’s EAT and QEAA services for reverse exchanges here.
Qualified Intermediary (QI): the third party entity that facilitates the exchange and holds the exchange proceeds to avoid the taxpayer’s actual or constructive receipt of funds. The QI may also be referred to as an ‘Exchange Accommodator’ or ‘Exchange Facilitator’. JTC is an industry-leading QI with an experienced team and a commitment to best practices.
Qualified Use: for a property to be included as part of a 1031 exchange, it must be used in a productive trade or business for a period of time. If the property is not being held for this qualified use, it will not be eligible for tax deferral under Section 1031.
Realized Gain: profits that have been earned but not yet subjected to taxation. In a successful exchange transaction, the gains are realized (i.e. converted to cash) but not yet recognized for tax purposes, and therefore remain untaxed.
Recognized Gain: the taxable gain on the disposal of property when it is sold or transferred at a profit in a taxable transaction.
REIT: A real estate investment trust (REIT) is an entity in which investors pool their resources by purchasing shares. The REIT uses this capital to acquire, own, and manage commercial properties on behalf of its shareholders. Unlike direct real estate investments, the individual REIT shares owned by investors are considered personal property, not real property, and therefore do not qualify for tax deferral under IRC §1031. It is possible to go from a 1031 property to a REIT through a 721 upREIT exchange.
Related Party: for the purposes of an exchange, a person is considered related to a taxpayer if they fall under the definitions provided in Sections 267(b) or 707(b)(1) of the Internal Revenue Code. This includes family members such as siblings, ancestors, and direct descendants. Additionally, an individual is deemed related to an entity like a partnership, LLC, or corporation if they own more than 50% of that entity.. Learn more about related-party exchanges here.
Relinquished Property: the property or properties being sold as part of a 1031 exchange.
Replacement Property: the property or properties being acquired as part of a 1031 exchange.
Reverse Exchange: in a reverse exchange, the replacement property is acquired first, followed by the sale of the relinquished property. Learn more by reading the JTC Reverse Exchange Guide.
Same Taxpayer Rule: this rule states that the taxpayer surrendering the relinquished property must be the same taxpayer that acquires the replacement property. To learn more about the same taxpayer rule and how it can trip up exchangers, read our guide to common 1031 mistakes.
Safe Harbor: the rules by which a taxpayer can execute a like-kind exchange over a period of up to 180 days. Forward and reverse exchanges have different Safe Harbor rules, but both require the use of a Qualified Intermediary so the taxpayer doesn’t take actual or constructive receipt of the sale proceeds during the exchange.
Sequential Deeding: unlike direct deeding, sequential deeding involves the seller deeding the property to a third party, who then deeds it to the buyer.
Simultaneous Exchange: a 1031 exchange in which the relinquished property is sold and the replacement property acquired at the same time.
State-to-State Exchange: a 1031 exchange involving properties located in different states or territories. Read more about state-to-state exchanges here.
Step Up in Basis: this tax policy assesses inherited assets based on their current market value rather than the value when the previous owner acquired them. For example, when a taxpayer dies, their heirs may receive a step up in basis for any properties they inherit. Should the heirs sell those properties, the basis for the gain will be calculated based on the date they inherited the property, not the date the original property was acquired. For more information, read our guide to 1031 and estate planning.
Swap Till You Drop: performing subsequent 1031 exchanges to continue tax deferral until death. For more information, read our guide to 1031 and estate planning.
Tax Basis Swapping: an exchange of a property with a high cost basis for a property with a low cost basis in order to reduce the capital gains recognized upon the taxable sale of the property. Rules for related-party exchanges exist to prevent tax basis swapping.
Tax Deferral: putting off payment of applicable taxes until a later date. It is a common misconception that a 1031 exchange eliminates tax liability. In actuality, taxes are merely deferred until a 1031 property is eventually sold in a taxable sale.
Tax Straddling: the practice of deferring recognition of a portion of the gain on the sale of an asset where at least one payment is to be received after the close of the taxable year in which the sale occurs. Tax straddling can be a method for hedging against 1031 failure.
Taxable Gain: the profit from a property sale that is subject to taxation. The basis must be used to calculate the taxable gain on a property sale in order to determine taxes due or the taxes that can be deferred through a 1031 exchange.
Taxable Sale: the sale of a property without the intent to perform a 1031 exchange. When a taxable sale is performed after a series of 1031 exchanges, the adjusted basis carried forward from the original acquisition is used to calculate the taxable gain.
Tenancy-in-Common (TIC): a type of ownership structure in which investors mutually own a property at different percentages, which can be changed at any time.
Three-Property Rule: exchangers can identify up to three properties (replacement properties in a forward exchange, relinquished properties in a reverse exchange), regardless of their individual or aggregate fair market value. The exchanger does not have to acquire all three properties for a successful exchange. Learn more about identification rules here.
Triple-Net Lease (NNN): a type of net lease arrangement in which the tenant pays property taxes, insurance, and maintenance costs. Learn more about triple-net leases here.
Have more questions about 1031 exchanges? Contact a JTC representative using the form below to receive a response to your specific query.
