Table of Contents
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1. What is a 1031 Exchange
Section 1031 of the Internal Revenue Code is one of the most powerful wealth-building tools available to real estate investors. When you sell an investment property at a profit, you typically owe federal capital gains tax (up to 20%), depreciation recapture tax (25%), the Net Investment Income Tax (3.8%), and potentially state and local taxes. For a profitable NYC commercial property, the combined tax liability can easily exceed 40% of the gain.
A 1031 exchange allows you to defer all of these taxes by reinvesting the proceeds into a qualifying replacement property. The key word is "defer" rather than "eliminate" -- the tax basis carries forward to the new property. However, investors can execute successive 1031 exchanges throughout their lifetime, and upon death, heirs receive a stepped-up basis that effectively eliminates the deferred gain entirely.
Core Requirements of a 1031 Exchange
- Both properties must be held for investment or productive use in a trade or business
- Properties must be "like-kind" (broadly defined for real estate -- any real property for any real property)
- A qualified intermediary (QI) must hold the proceeds during the exchange period
- Strict identification and closing deadlines must be met (45 and 180 days)
- The replacement property value must equal or exceed the relinquished property value
2. Qualifying Properties
The Tax Cuts and Jobs Act of 2017 limited 1031 exchanges exclusively to real property. Previously, personal property such as equipment, vehicles, and artwork could also qualify. Today, only real estate held for investment or business use is eligible. The good news is that the "like-kind" definition for real estate is extremely broad.
Properties That Qualify
- • Office buildings and commercial properties
- • Retail centers and shopping plazas
- • Multifamily apartment buildings
- • Industrial and warehouse facilities
- • Vacant land held for investment
- • Mixed-use properties
- • Triple net leased (NNN) properties
- • Delaware Statutory Trusts (DSTs)
Properties That Do NOT Qualify
- • Primary residences
- • Second homes used primarily for personal use
- • Property held for resale (fix-and-flip)
- • Stocks, bonds, or partnership interests
- • Foreign real property (cannot exchange for US property)
- • Property converted to personal use before sale
One of the most compelling aspects of 1031 exchanges is the ability to exchange any type of real estate for any other type. An investor can sell a Manhattan office building and purchase a portfolio of NNN retail properties in the Southeast, or sell a vacant parcel and acquire a multifamily building. This flexibility allows investors to reallocate their portfolios strategically while deferring taxes.
3. Timeline Requirements
The 1031 exchange process is governed by two non-negotiable deadlines that begin on the date the relinquished property closes. Missing either deadline disqualifies the entire exchange and triggers full tax liability.
The Two Critical Deadlines
45-Day Identification Period
Within 45 calendar days of closing on the sale of your relinquished property, you must identify potential replacement properties in writing to your qualified intermediary. This identification must be specific -- including the address and legal description. The 45-day deadline includes weekends and holidays with no extensions.
180-Day Exchange Period
You must close on the replacement property within 180 calendar days of selling the relinquished property (or by the due date of your tax return, including extensions, whichever comes first). The 180-day period runs concurrently with the 45-day identification period -- not after it.
Identification Rules
The IRS provides three methods for identifying replacement properties during the 45-day window:
- Three-Property Rule: Identify up to three properties of any value
- 200% Rule: Identify any number of properties whose combined value does not exceed 200% of the relinquished property value
- 95% Rule: Identify any number of properties if you acquire at least 95% of the aggregate value identified
4. Rules & Restrictions
To achieve full tax deferral, the exchange must satisfy several critical requirements. Failing to meet any of these conditions may result in partial or complete recognition of the capital gain.
Equal or Greater Value
The replacement property must have a purchase price equal to or greater than the net sale price of the relinquished property. Any difference in value is called "boot" and is taxable. Boot can be cash received, debt reduction, or non-like-kind property received in the exchange.
Qualified Intermediary Requirement
The exchanger cannot touch the sale proceeds at any point. A qualified intermediary (also called an accommodator) must hold the funds from the sale through the acquisition of the replacement property. The QI cannot be your agent, attorney, accountant, or anyone who has acted in those capacities within the prior two years.
Same Taxpayer Requirement
The entity or individual that sells the relinquished property must be the same entity or individual that acquires the replacement property. An LLC selling a property cannot have its individual members purchase the replacement in their personal names without triggering tax consequences.
Held for Investment or Business
Both the relinquished and replacement properties must be held for productive use in a trade or business or for investment. The IRS examines the taxpayer's intent at the time of the exchange. There is no specific minimum holding period in the statute, but most tax advisors recommend holding for at least one to two years to demonstrate investment intent.
5. Reverse Exchanges
In a standard (forward) 1031 exchange, you sell first and then buy. A reverse exchange flips this order -- you acquire the replacement property before selling the relinquished property. This is particularly useful in competitive markets like NYC where desirable properties sell quickly and waiting to sell first could mean losing the opportunity.
How Reverse Exchanges Work
- Exchange Accommodation Titleholder (EAT): An EAT takes title to either the replacement property or the relinquished property during the exchange period, since the investor cannot own both simultaneously.
- Parking Arrangement: Under Revenue Procedure 2000-37, the EAT "parks" the property for up to 180 days while the investor completes the sale of the relinquished property.
- Higher Costs: Reverse exchanges are more complex and expensive than forward exchanges, typically costing $10,000-$25,000 or more in accommodator fees, plus potential additional financing costs.
- Same Deadlines Apply: The 45-day identification and 180-day exchange periods still apply, measured from the date the EAT acquires the parked property.
Reverse exchanges are particularly valuable for NYC investors who find an irreplaceable acquisition opportunity but need time to market and sell their existing property. While the additional cost can be significant, it pales in comparison to the capital gains taxes deferred through a successful exchange.
6. NYC-Specific Considerations
New York City commercial real estate investors face unique considerations when executing 1031 exchanges. The combination of high property values, state and city taxes, and competitive market dynamics makes planning even more critical.
NY State Tax Benefits
New York conforms to federal 1031 exchange rules, so a qualifying exchange defers both federal and state capital gains taxes. With NY state rates up to 10.9% and NYC rates up to 3.876%, the additional state/city deferral is substantial.
Transfer Tax Considerations
NYC transfer taxes (including the mansion tax for properties over $1M) apply to both the sale of the relinquished property and the purchase of the replacement property. These transfer costs cannot be deferred through a 1031 exchange.
Out-of-State Replacement
Many NYC investors use 1031 exchanges to diversify into lower-cost, higher-cap-rate markets. Exchanging a $10M Manhattan property for multiple properties in growth markets like Texas or Florida can dramatically increase cash flow while deferring taxes.
Competitive Timing Pressure
NYC's competitive market means identifying and securing replacement properties within 45 days can be challenging. Smart investors pre-identify potential replacement properties before selling and consider reverse exchanges for must-have acquisitions.
Skyline Properties has facilitated hundreds of 1031 exchanges for NYC commercial real estate investors. Robert Khodadadian works closely with tax advisors, attorneys, and qualified intermediaries to ensure transactions are structured properly and replacement properties are identified well within required timelines.
7. Frequently Asked Questions
Can I do a 1031 exchange into a property I already own?
No. The replacement property must be a property that the taxpayer does not already own at the time of the exchange. You cannot exchange into a property you currently hold title to. However, you can exchange into a property owned by a related party in certain circumstances, though special rules and a two-year holding requirement apply.
What happens if I only reinvest part of the proceeds?
If you reinvest less than the full net sale proceeds, the difference is treated as "boot" and is taxable. For example, if you sell for $5 million and only reinvest $4 million, the $1 million difference is recognized as a taxable gain. To defer 100% of the tax, you must reinvest all proceeds and replace all debt.
How many times can I do a 1031 exchange?
There is no limit on the number of 1031 exchanges you can perform. Many sophisticated investors execute serial exchanges throughout their careers, continuously deferring taxes and growing their portfolios. Upon death, heirs receive a stepped-up cost basis, effectively eliminating all deferred gains -- making 1031 exchanges a powerful generational wealth strategy.
Can I exchange into a Delaware Statutory Trust (DST)?
Yes. DSTs are treated as direct property ownership for 1031 exchange purposes under IRS Revenue Ruling 2004-86. DSTs are particularly popular with investors who want to defer taxes while transitioning to passive management. They provide fractional ownership in institutional-quality properties with professional management, making them an excellent option for retiring investors or those seeking to diversify without active landlord responsibilities.