Is Capital Gains Tax Applicable to Stock Options?

When it comes to taxes, stock options can be a desirable benefit for employees, but it can also raise questions about capital gains. In this article, we'll dive into the details of capital gains and how they apply to stock options, so employees can better understand the tax implications of this popular employer perk.

Capital Gains

When it comes to capital gains and stock options, it's important to understand how they are taxed. A capital gain is the profit made from selling a capital asset such as stocks, bonds, or real estate for more than the original purchase price. How long the asset was held before selling it determines whether the gain is considered short-term or long-term.

Short-term capital gains are gains from selling assets held for one year or less and are taxed as ordinary income, which can be as high as 37% for the tax year 2022, depending on your tax bracket. On the other hand, long-term capital gains are gains from selling assets held for more than one year and are taxed at a lower rate than short-term gains.

The tax rate for long-term capital gains depends on the taxable income and ranges from 0% to 20%. The majority of individual taxpayers pay a tax rate on net capital gains of no more than 15%, according to the IRS.

Stock Options

Stock options are a popular form of compensation used by companies to attract and retain employees. Essentially, stock options are contracts that give the employee the right to buy a certain number of shares of the company's stock at a pre-determined price, known as the grant price. This grant price is typically lower than the current market price of the stock, which allows the employee to potentially make a profit if the stock price rises.

Stock options come in different forms, including non-qualified stock options (NSOs) and incentive stock options (ISOs). NSOs are more common and are typically offered to all employees, while ISOs are reserved for executives and other key employees. ISOs have more favorable tax treatment, but they also come with more restrictions and rules.

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When a company offers stock options as compensation to its employees, it grants them a contract that allows the employee to purchase a set number of shares of the company's stock at a predetermined price, which is usually lower than the current market value. While holding the stock options, the employee does not have an ownership interest in the company, but exercising them to buy the stock provides them with the ownership interest.

There are two types of stock options: statutory and non-statutory. Statutory stock options are granted under either an employee stock purchase plan or an incentive stock option (ISO) plan, which both have specific rules and regulations that must be followed. Non-statutory stock options, also known as non-qualified stock options (NSOs), are granted without any type of plan and are typically more flexible in terms of their terms and conditions.

Capital Gains and Stock Options

When it comes to capital gains and stock options, the tax implications start when the options are exercised. At that point, the tax liability is based on the difference between the fair market value of the shares and the exercise price. This difference is known as the "spread". The spread is taxed as ordinary income, subject to income tax withholding and payroll taxes.

When an employee sells the shares acquired through exercising their stock options, any gain or loss is treated as a capital gain or loss. If the shares have been held for more than one year, any gain is subject to long-term capital gains tax rates, which are generally lower than ordinary income tax rates. However, if the shares have been held for one year or less, any gain is subject to short-term capital gains tax rates, which are the same as ordinary income tax rates.

The tax treatment of stock options also differs depending on whether they are statutory or non-statutory options. Statutory stock options, such as those granted under an employee stock purchase plan or incentive stock option (ISO) plan, have special tax treatment. When ISOs are exercised and the shares are sold, the gain or loss is generally taxed as a long-term capital gain or loss. However, there are certain holding period and other requirements that must be met for the special tax treatment to apply.

Non-statutory stock options, also known as non-qualified stock options (NSOs), do not receive the same special tax treatment as ISOs. Instead, the spread between the fair market value of the shares and the exercise price is taxed as ordinary income when the options are exercised. Any gain or loss on the sale of the shares is then taxed as a capital gain or loss.

It is crucial to hold stocks obtained through an employer's stock options program for at least a year, regardless of whether they are ISOs or NSOs, to take advantage of the lower tax rate for long-term capital gains.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

Why a 1031 Exchange May Be Smart Financial Planning

Should I pay the taxes, or defer? When selling real estate investment property, investors generally have two options: 1) pay the taxes on any gains from the sale, or, 2) conduct a 1031 exchange and defer the taxes owed. When it comes to smart financial planning, you want to make sure you're on the right page

Recently, because of the financial uncertainty surrounding COVID-19 and the overall state of the economy, some investors are choosing to pay the taxes on any gain from the sale of their investment properties and hold on to their cash rather than acquire replacement real estate utilizing the 1031 process.

While every investor is different and should make their own determination of their specific financial landscape and rely on the advice of their professional financial and legal counsel, there are generally two major points to keep in mind before choosing to pay the taxes rather than defer.

Point #1: the amount of taxes you might have to pay

If you choose to pay the taxes on your gain, you might be responsible for the following:

- Long term federal capital gains tax rate may be as high as 20%, depending on your income bracket.

- State tax can also add to the financial tax hit, depending on the State in which you live. For example, in California, an investor could possibly also pay up to 13.3% in income tax.

- Depreciation recapture is taxed at a flat rate of 25%, which can be quite significant if you’ve held and depreciated your investment property for a long period of time.

- Net Investment Income Tax (NIIT) applies to certain net investment income of investors that have income above the statutory threshold, at a rate of 3.8%.

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Point #2: opportunity cost of any amount you pay in taxes

When an investor pays taxes, that could otherwise be deferred, they’re left with less capital that could otherwise be used for investment purposes that could generate more return for them.

Let’s use a simple example: Suppose that an accredited investor sells an investment property for $1 million, and the total amount of taxes that they would owe on such sale is $200,000. That accredited investor then decides, for purposes of our example, that they will pay the taxes owed and take the $800,000 in cash remaining and invest it in some investment that pays 5% annual interest. That investor, based on our example, should make a return of $40,000 per year.

However, if that same accredited investor had completed a 1031 exchange, for example into a DST, or Delaware Statutory Trust, paying 5% annually, their annual return should be $50,000, a difference of $10,000. While the above is a simplified example, it helps illustrate the opportunity cost of paying the taxes rather completing a 1031 exchange.

Before an investor decides to pay any owed taxes on the sale of their investment property rather than completing a 1031 exchange and deferring those taxes, they should thoroughly understand the financial implications by consulting with their professional tax advisor.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. The scenario provided above is a hypothetical illustration of mathematical policies only and is not a promise of investment performance.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

• There is no guarantee that any strategy will be successful or achieve investment objectives;

• Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;

• Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;

• Potential for foreclosure – All financed real estate investments have potential for foreclosure;

• Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

• Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;

• Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

The Potential Benefits of Using DSTs for Estate Planning

Baby Boomers are one of the nation’s largest demographics and by some estimates, more than 10,000 are reaching the retirement age of 65 each day. As Baby Boomers prepare to retire, many place a renewed focus on estate planning.

Estate planning used to be considered something that only the super wealthy had to worry about. When middle-income families then found their assets tied up and disputed in probate court, more people started to realize the many benefits associated with estate planning – regardless of how much wealth you hope to pass on to heirs. Without an estate plan, the courts often decide who inherits what. This process can be lengthy, costly, and lead to family strife in the process.

Estate planning is a great way to potentially a) protect your beneficiaries and b) preserve the wealth you’ve worked so hard to create. DSTs, in particular, are a potentially great way to maximize the value of real estate assets that can then be passed down to heirs.

In this article, we look at the specific benefits of DSTs for estate planning purposes.

What is a DST?

A Delaware Statutory Trust, or DST, is a real estate investment vehicle that allows individuals to own a fractional share of institutional-quality assets. DSTs are managed by third-party real estate sponsors. The sponsors identify, acquire, and then manage the DST’s assets on investors’ behalf.

The properties held by a DST are considered a “like-kind” exchange, and therefore, investors can sell their individually-owned properties and roll the proceeds of the sale into a DST through a 1031 exchange. In doing so, they can defer paying capital gains tax – sometimes indefinitely.

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How to Use a DST for Estate Planning Purposes

Many investors, especially those who are at or nearing retirement age, decide that they no longer want to actively manage their real estate holdings. Owning property individually can be time consuming and stressful. You’re dealing with tenants, repairs and maintenance, costly capital improvement projects, ongoing marketing and leasing efforts and the like. For those who own many rental properties, these headaches can become overwhelming during a phase of life where they otherwise want to relax and spend time doing more pleasurable things.

Those who are looking to simplify their investments and transition to more passive ownership will want to consider investing in a DST.

With a DST, investors can sell off their real estate portfolios (in whole or in part) and reinvest the proceeds into a DST. Using a 1031 exchange to do so, investors can defer paying capital gains tax. This is especially valuable to those who have been long-term holders of real estate, as the properties have likely taken most or all applicable depreciation and have likely appreciated in value. These properties would otherwise be subject to hefty capital gains tax.

Once the proceeds of a real estate sale are invested into a DST, the DST investor can place those beneficial ownership interests into their personal trust for the benefit of their heirs.

Upon the owner’s death, the real estate assets held in that trust receive a stepped-up basis, meaning that the property’s value is assessed based on the time of the owner’s death rather than the value when it was first acquired. This will reduce the tax burden on the heirs and may be able to serve as a tremendous wealth preservation strategy.

The Potential Benefits of Using DSTs for Estate Planning

There are many potential benefits associated with DSTs when used for estate planning purposes. These benefits include:

Elimination of Capital Gains Tax: As noted above, through careful planning, a real estate investor can leverage a DST to avoid paying capital gains tax after selling their individually-owned real estate assets. Using a 1031 exchange, they can sell property and then roll the proceeds into a DST. Doing so allows them to defer paying capital gains tax. If those DST interests are placed in a trust and the DST shareholder passes away, the beneficiaries of the trust receive the stepped-up basis (i.e., the value of the property at the time of the owner’s death). Therefore, they will not have to pay any capital gains tax if they elect to sell at the time of the owner’s death.
Transition from Active to Passive Investments: Those who own real estate individually are responsible for day-to-day oversight, including leasing, responding to tenant requests, and tending to the property and any associated repairs and maintenance. They are also on the hook for any costly capital improvement projects, such as replacing a roof or HVAC system. As investors approach retirement age, many want to simplify their lives and reduce their management responsibilities. Selling properties and investing the proceeds into a DST is a great way to move from active real estate investing to passive real estate investing, as the sponsor of the DST will be in charge of all property activities on the investors’ behalf.

Passive real estate investments are also specifically attractive in the context of estate planning. Let’s say, for example, that someone owns a 200-unit apartment building. When that person passes away, their children inherit the property. The children may have little to no real estate experience and may have no interest in managing the property.

However, just because the children are ill-equipped to manage the property doesn’t mean the property won’t still need immediate and ongoing maintenance. Situations like these often result in properties falling into a state of disrepair, which ultimately erodes the property’s value. Instead, someone who has invested in a DST has the peace of mind that if they pass away, their children benefit from the DST’s real estate holdings without taking on the responsibility of property management.

Portfolio Diversification: Institutional investors, such as pension funds, endowments and insurance companies, have invested in high-quality commercial real estate for decades. Their ability to bring tens of millions of dollars to a transaction often gives them an upper-hand in purchasing some of the nation’s most desirable real estate. Consider Yale University, which has one of the highest performing endowments of all time. Nearly 30 years ago, Yale made a strategic decision to reduce the endowment’s reliance on stocks and bonds and instead, invested more heavily in real estate. Today, the endowment invests approximately 20 percent of its funds in real estate – a staggering number when compared to individual investors who have, on average just 3 percent of funds allocated to real estate.
Investing in a DST is a great way for investors to remain diversified and in turn, to ensure that their heirs have access to real estate assets. Moreover, investing in a DST provides access to institutional-quality real estate that would otherwise be inaccessible to everyday, retail investors.
Reduce Likelihood of Family Disputes: One of the primary benefits associated with using a DST for estate planning purposes is that it reduces the likelihood of family disputes. Let’s consider a few different scenarios.
Scenario 1: An individual owns a 200-unit apartment building that has been left in a trust for the mutual benefit of their heirs. There are three beneficiaries to the trust. When the owner passes away, the beneficiaries must decide what to do with the property. None of them have real estate experience. One prefers to hold the property indefinitely, maintaining the father’s legacy as a real estate investor. One wants the others to buy them out. The third thinks they should sell the property outright and divide the proceeds equally amongst themselves. The siblings are at odds with how to proceed, and in the interim, bills continue to rack up and the property begins to fall into a state of disrepair. This gridlock leads to family disputes, name-calling and ill-will amongst three siblings who otherwise got along well.
Scenario 2: An individual owns five rental properties, each in different geographies and worth different amounts. A family trust lists the five properties and specifies an heir for each. Properties 1, 2 and 3 are slated to go to Child A and Properties 4 and 5 are slated to go to Child B. At the time the trust was created, this division of properties was roughly equal in value. However, when the owner passes away ten years later, the value of the properties is drastically different, leading to an uneven distribution of assets amongst the two children. Per the trust, Child A receives real estate worth nearly twice as much as Child B, causing Child B to contest the validity of the trust. The two children remain at odds until the dispute is resolved in probate court, but by that time, irreparable damage had been done to the siblings’ relationship.
Scenario 3: An individual investor is approaching retirement age and, in an attempt to simplify their real estate portfolio, sells an individual asset, the proceeds of which are rolled into multiple DSTs using a 1031 exchange. The proceeds are structured as three separate DST investments, each worth the same amount. The investor has 3 children. The DST investments are placed into a trust, and the trust identifies each child as the singular beneficiary for each of the 3 DSTs – one DST per child. When the owner passes away, the children each have real estate assets potentially worth the same value. In the meantime, the sponsor for each DST continues to oversee the asset(s) owned by the DST on the children’s behalf. Once the DST asset is sold by the sponsor, each child can decide whether they want to cash out their interest in their respective DST or do a 1031 exchange to continue deferring the taxes.

Clearly, Scenario 3 is the best way to reduce the likelihood of family disputes. It gives many investors comfort knowing that DST investments can be structured to ensure parity amongst their heirs when they pass.

Considerations When Using DSTs for Estate Planning Purposes

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There are a few other considerations for investors when thinking about using a DST for estate planning. The first thing to realize is that DST investments are illiquid. When someone invests in a DST, the holding period may be anywhere from five to seven years, so an investor should expect their money to be tied up for at least that long. This may be good or bad in the context of estate planning purposes.

If an investor passes away during that hold period, their heirs may be forced to wait the balance of the hold period before selling their shares – a period of time that can give them time to understand the implications of continuing to hold the DST investment vs. selling their interest (vs. making a gut-reaction decision at the time of the owner’s death).

Conversely, heirs who are hoping to access the value of the real estate asset in the short-term may be frustrated by their inability to liquidate shares during the balance of the hold period.

Secondly, DST investments are truly passive. This means that the heirs will have little to no say in the direction of the DST portfolio. For example, they cannot influence if and when properties are purchased or sold. They cannot weigh in on a property’s repositioning strategy.

They are passive investors and all portfolio decisions are made by the DST sponsor. Those with little real estate experience will appreciate this oversight, but those who want to be more hands-on real estate investors may prefer owning their own property outright.

Conclusion

Estate planning is important for all individuals, regardless of whether they own real estate or not. However, those who own real estate will want to pay close attention to what happens to that property if they pass away. Having a solid estate plan in place can help to avoid probate court and reduce family strife.

DSTs are a great way to do just that. What’s more, the indefinite deferral (or entire elimination) of capital gains tax ensures that the value the owner has worked so hard to create is passed on in full to their heirs.

Are you considering a DST investment? Contact Perch Wealth today to learn more about your 1031-exchange real estate investment options.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only and should not be relied upon to make an investment decision. All investing involves risk of loss of some, or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

1031 Risk Disclosure:

• There is no guarantee that any strategy will be successful or achieve investment objectives;

• Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;

• Potential for foreclosure – All financed real estate investments have potential for foreclosure;

• Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

• Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Ensuring Your 1031 Exchange is Successfully Transacted

Selling investment or business real estate can be costly, but a 1031 exchange can help preserve gains and generate wealth. Under Section 1031 of the federal tax code, no gain or loss is recognized on the sale of a real estate property held for business or investment purposes if a replacement property of equal or greater value is purchased. However, the 1031 exchange process can be complex. To help guide your clients through a successful exchange, consider these steps:

Step 1

Be aware of the deadlines set by the IRS. Investors have 45 days to identify a replacement property and 180 days to close on it after selling the relinquished property. It may seem like a short time frame, but it is manageable with the help of a professional 1031 exchange investment firm such as Perch Wealth.

Step 2

The IRS requires that an exchanger reinvest in a “like-kind” property, but this does not necessarily mean the same type of property. There are various options available. For example, if you are selling a duplex, you don't have to replace it with another duplex.

The 1031 exchange allows investors to replace relinquished real estate with different types of assets such as a medical building, single-family home, multifamily apartment building, raw land, self-storage facility or any other investment real estate as long as it is held for investment or business purposes.

It is best to know what you are looking for in a replacement property before going into escrow on the property you are selling. Working with a 1031 exchange investment firm like Perch Wealth can greatly reduce the stress and confusion surrounding 1031 exchanges.

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Step 3

It is not uncommon for 1031 exchange investors to feel overwhelmed and stressed when they reach the 30-day mark of their 45-day window without a replacement property identified for their exchange. However, with some planning and preparation, you can avoid this situation.

A good strategy is to identify five to ten potential replacement properties as the closing date of the property you are selling approaches. Keep in mind that some of these properties may be acquired by other buyers or may not be suitable after further evaluation, which is why it is important to have a short list of potential replacement properties before relinquishing the original asset. This can help prevent your 1031 exchange from falling apart.

Step 4

It is not uncommon for investors to call in a panic because they have found a replacement property, but they are unable to secure financing to purchase it. To avoid this stressful and potentially costly situation, it is important to ensure that financing is in place before closing on the property being sold.

One solution is to consider fractional ownership structures for 1031 exchanges, such as a Delaware Statutory Trust (DST) investment for accredited investors. DSTs have a non-recourse financing component built-in, so the investor does not need to sign for a loan. This can make a DST an ideal opportunity for an investor looking for a passive, turn-key solution with pre-established financing for their 1031 exchange.

Step 5

According to the IRS code, investors have options for identifying replacement properties for their 1031 exchange. The most common methods are identifying three properties at any value or identifying real estate valued at up to 200% of the property being sold.

This allows for back-up options. It is important to take advantage of this opportunity and not leave any empty spaces on the ID form submitted to the qualified intermediary. Often, the primary option may not work out, and having back-up options can strengthen the investor's negotiating power by providing additional choices.

For accredited investors, a Delaware Statutory Trust (DST) can be an excellent back-up strategy. DST properties are already purchased, stabilized, and may provide monthly distributions to investors. There is no need for negotiation and due diligence is already complete.

Additionally, closing on a DST can often be done in three to five business days. It is a good idea to consider using a DST as a back-up ID if there is room in the exchange and it is appropriate for the investor's situation.

Step 6

When entering into a purchase and sale agreement, it is important to include a 1031 contingency clause. Many buyers are willing to allow a 1031 contingency that allows the seller to extend escrow on the property being sold if the seller is unable to find a replacement property. For example, try to negotiate a clause that extends escrow by an additional 30 days in case you are unable to identify a suitable replacement property. This can provide extra time if needed when locating the right 1031 exchange investment.

In summary, a 1031 exchange can be a valuable tool for building and preserving wealth, but it can also be a challenging process if not properly prepared. To ensure a successful exchange, start early, educate yourself, narrow down options, secure financing, have a back-up plan, and negotiate for more time if needed.

For accredited investors, consider using a Delaware Statutory Trust (DST) as part of your 1031 exchange strategy. Keep in mind that there are no guarantees in real estate, so it is always best to plan ahead when considering a 1031 exchange.

Understanding a "Like-Kind" Exchange's Holding Period

Every investor must adhere to rigorous deadlines in order to effectively conduct a 1031 exchange. However, investors frequently inquire as to whether a property must be held for a specific period of time in order to be eligible for an exchange. Although the IRS hasn't stated a holding time specifically, a few factors could shed light on the matter.

During the 1031 Holding Period

How long an investor keeps a piece of property is known as the holding period. IRC Section 1031 does not specify the length of the holding period, as was previously indicated. Instead, it depends on the investor's goals.

No gain or loss shall be recognized on the exchange of property held for productive use in a business, according to the IRS.

"Even though properties vary in grade or quality, they are still of the same sort if they have the same nature or character.

Whether they are renovated or unimproved, real estate properties are often of a like kind. An apartment building would often be similar to another apartment building, for instance. However, real estate within the United States is not comparable to real estate outside.

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Recognizing Intent

The goal of Section 1031 is to make it possible for investors who have owned their property for a long time, particularly those who did so for income-producing purposes, to exchange it for another property that would serve the same function.

Since not all real estate is owned for the same purpose, not all of it is eligible. A primary residence is the most frequent case that should be considered. A primary residence does not qualify for an exchange since it is not "kept for productive use in a trade or industry or for investment." On the other hand, because they are held as investments, residential complexes, office and medical buildings, shopping malls, and single-tenant assets typically qualify.

In order to achieve a 1031 exchange, developers must overcome additional obstacles. Purchasing land, constructing a property, and then selling it for a profit frequently disqualifies a transaction from a 1031 exchange since a property must be held for investment purposes. In this case, the property was held for profit-making purposes rather than as an investment.

If investors are unsure whether the property will satisfy Section 1031, they should think about holding it for at least one year, if not two.

Even while the IRS has never explicitly said that there must be a minimum hold period, there have been instances where the IRS refused to allow an exchange because the owner's intent was ambiguous.

Investors who are unsure of their eligibility may choose to follow the two-year advice in general. However, as always, consult with a tax expert to receive their opinion on your specific case. The IRS referred to the two-year holding term in Private Letter Ruling 8429039 from 1984. The letter was written in response to a request for an exchange from an investor who wished to sell his property. Until 1981, the subject property served as the investor's primary residence. The investor leased out the property in 1983. The IRS granted the investor's request for a 1031 exchange in 1984, noting that keeping rental property for at least two years satisfies the holding period test required by Section 1031. But since a private letter ruling only applies to this specific instance, it may only be regarded as a general recommendation for 1031 exchanges.

The one-year holding consideration, on the other hand, was first proposed by Congress in 1989 as a requirement for a property to be eligible for a 1031 exchange. However, because this suggestion was never included in the Tax Code, it is not necessary. Instead, in order to determine whether a property would be eligible under Section 1031, tax professionals have referred to this idea.

The fact that the investment will appear on one's taxes as an investment property for two filing years if it is held for at least a year is another factor for the one-year holding period.

Nevertheless, these factors are but that—factors. In the past, the IRS has made choices on like-kind exchanges that do not support these ideas. For instance, in the case Allegheny County Auto Mart v. C.I.R. from 1953, the court allowed an investor to complete a 1031 exchange even though they had only owned the property for five days. However, in other cases, like Klarkowski v. Commissioner from 1967, an investor was still ineligible even after six years of ownership.

Is a vacation home acceptable?

Those who own property as a vacation home can often sell it and buy a new property via a 1031 exchange, however this is typically how commercial investors talk about 1031 exchanges. The vacation home must, however, have tenants, and it must be managed like a company. In addition, if the vacation home is purchased as the replacement property, the investment-related use of the property must continue. The property can usually not be turned into a primary residence within five years of the exchange.

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Additional 1031 Exchange Timelines That Are Important

Investors must be aware of and abide by the deadlines specified in Section 1031 in order to be eligible for a like-kind exchange.

There is no time limit on how long an investor has to sell an asset after it is put on the market. They can market it for one day or five years and sell it on or off the open market. In reality, they have the option to list the asset before deciding otherwise. Any gains are unrealized until the property is sold. A timetable doesn't begin until the property actually closes, and the investor may be liable for paying taxes on the realized gains.

An investor has 45 days to choose their replacement property and 180 days to close after the initial property, or surrendered property, closes. The 180-day period begins on the same day as the property's closure. With very few exceptions, every exchange that doesn't take place by these dates has all gains subject to taxation.

Speak with a Professional You Can Trust

Speaking with a trained professional is highly advised for anyone considering selling their real estate and buying a new property via a 1031 exchange. Many 1031 swaps have distinct looks. In addition to providing insight on the potential exchange, 1031 experts can lead investors to other 1031 exchange investment opportunities that might otherwise go unnoticed.

General Disclosure

1031 Risk Disclosure:

There is no guarantee that any strategy will be successful or achieve investment objectives;
Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
Potential for foreclosure – All financed real estate investments have potential for foreclosure;
Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

The Importance of a QI in Your 1031 Exchange

A qualified intermediary (QI) is required for all 1031 exchanges. Given the importance of the QI in an exchange, it is imperative for real estate investors to identify one they can trust and rely on. Achieving this, however, can be difficult – how does an investor know whether a particular QI is credible? Here is a brief tutorial on how to select a reputable QI for a 1031 exchange.

What is a QI?

A QI, also known as an accommodator, is an individual or entity that facilitates a 1031, or like-kind, exchange as outlined in Internal Revenue Code (IRC) Section 1031. The role of a QI is defined in the Federal Code as follows:

A qualified intermediary is a person who -

(A) Is not the taxpayer or a disqualified person, and

(B) Enters into a written agreement with the taxpayer (the “exchange agreement”) and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer. (26 CFR § 1.1031(k)-1)

An individual does not need to meet any eligibility requirements or acquire a license or certificate to become a QI. However, the Internal Revenue Service (IRS) does stipulate that anyone who is related to the exchanger or has had a financial relationship with the exchanger – such as an employee, an attorney, an accountant, an investment banker or broker, or a real estate agent or broker – within the two years prior to the sale of the relinquished property is disqualified from acting as the exchanger’s QI.

Why is having a QI important in a 1031 Exchange?

Every 1031 exchanger must identify a QI and enter into a written contract prior to closing on the relinquished property. Once selected, the QI has three primary responsibilities: prepare exchange documents, exchange the properties, and hold and release the exchange funds.

Preparing Exchange Documents

Throughout the exchange, the QI prepares and maintains all relevant documentation, including escrow instructions for all parties involved in the transaction.

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Exchanging Properties

A 1031 exchange requires the QI to acquire the relinquished property from the exchanger, transfer the relinquished property to the buyer, acquire the replacement property from the seller, and transfer the replacement property to the exchanger. Although the QI also transfers the title, the QI does not actually have to be part of the title chain.

Holding and Releasing Exchange Funds

For an exchanger to defer capital gains, all proceeds from the sale of the relinquished property must be held with the QI; any proceeds held by the exchanger are taxable. Therefore, the QI must take control of the proceeds from the sale of the relinquished property and place them in a separate account, where they are held until the purchase of the replacement property.

Exchangers must meet two key deadlines for the exchange to be valid. The first comes at the end of the identification period. Within 45 calendar days of the transfer of the relinquished property, the exchanger must identify the replacement property to be acquired. The second comes at the end of the exchange period. The exchanger must receive the replacement property within 180 calendar days of the transfer of the relinquished property. These deadlines are strict and cannot be extended even if the 45th or 180th day falls on a Saturday, Sunday, or legal holiday.

What should investors consider when choosing a QI?

Since a QI is not required to have a license, investors should conduct due diligence to ensure they select an individual who can properly manage the 1031 exchange. Unfortunately, the IRS does not excuse any errors committed by a QI, and, as a result, investors may be required to pay taxes on the exchange due to these mistakes. Here are a few things investors should consider when selecting a QI.

State Regulations

While the federal government does not regulate QIs, some states have enacted legislation that does. For example, California, Colorado, Connecticut, Idaho, Maine, Nevada, Oregon, Virginia, and Washington have all passed laws overseeing the industry. Many of these states have requirements for licensing and registration, separate escrow accounts, fidelity or surety bond amounts, and error-and-omission insurance policy amounts.

Federation of Exchange Accommodators

The Federation of Exchange Accommodators (FEA) is a national trade association that represents professionals who conduct like-kind exchanges under IRC Section1031. The FEA’s mission is to support, preserve, and advance 1031 exchanges and the QI industry. Association members are required to abide by the FEA’s Code of Ethics and Conduct.

In addition, the FEA offers a program that confers the designation of Certified Exchange Specialist® (CES) upon individuals who meet specific work-experience criteria and pass an examination on 1031 exchange laws and procedures. Holders of this certificate must pass the CES exam and meet continuing education requirements. The “designation demonstrates to taxpayers considering a 1031 exchange that the professional they have chosen possesses a certain level of experience and knowledge.”

Knowledge and Experience

As mentioned, a QI’s mistake in a 1031 exchange can result in a taxable transaction. Investors who are in the process of selecting an accommodator should review each individual’s qualifications – including knowledge and experience in the industry – before making a final decision. Investors should inquire whether the individual is full- or part-time; how many transactions and how much in value the individual has facilitated. Additionally, it is important to know whether the individual has any failed transactions and, if so, why.

Knowledge about 1031 exchanges is critical. Not only should potential QIs know the basics, but they should understand the ins and outs of the 1031 exchange process. For example, QIs should know what qualifies as a like-kind property. Likewise, they should know about Delaware Statutory Trusts (DSTs), one of the most commonly overlooked alternative 1031 exchange solutions. Unfortunately, many QIs are not familiar with DSTs. Finding a knowledgeable and experienced QI is crucial for investors who want to successfully defer capital gains while continuing to meet their overall financial objectives.

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How should an investor go about selecting a QI?

To find a QI in good standing, investors should seek referrals. Word of mouth can be a great way to find a credible QI. Investors can ask for a referral from a certified public accountant (CPA) with 1031 exchange experience, a real estate attorney, a reputable title company, or even the other party in the exchange.

When vetting a potential QI, investors need to ask questions that will reveal the individual’s depth of knowledge and experience – beyond just the basics. For instance, the FAE requires potential QIs to work full-time for at least three years before they can even sit for the CES exam. Three years is a good baseline to start from when judging a QI’s experience; five to 10 years is a solid amount.

Finding a QI is one of the most critical parts of a 1031 exchange, as the transaction cannot be completed without one. Investors must ensure that their QI is experienced and thoroughly understands the various tax codes involved. Investors also need to ensure that the QI has not been financially connected to them within the past two years and is not a relative, employee, or agent. The IRS does not take these factors lightly; failure to comply with what is presented here may lead to hefty penalty fees – or the IRS may prohibit the exchange from occurring altogether.

General Disclosure

1031 Risk Disclosure:

There is no guarantee that any strategy will be successful or achieve investment objectives;
Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
Potential for foreclosure – All financed real estate investments have potential for foreclosure;
Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits