Hawai’i 1031 Exchange: Your Complete Guide to Deferring Taxes and Maximizing Investments

Hawaii 1031 Exchange: The Ultimate Guide to Tax-Deferred Investing

Henry is a licensed mainland attorney with extensive experience in law and real estate. While he does not offer legal or tax advice specific to Hawaii, Henry leverages his legal background and deep understanding of real estate investments to guide investors effectively through the Hawaii 1031 exchange process.

Disclaimer: This information is general and educational. Always consult your tax advisor, CPA, or a Hawai’i-licensed attorney before making decisions related to a Hawai’i 1031 exchange.

What is a 1031 Exchange in Hawaii?

A 1031 exchange named after Section 1031 of the Internal Revenue Code (also known as a like-kind exchange), allows investors to defer capital gains taxes when selling an investment property by reinvesting proceeds into another similar or "like-kind" property. In Hawaii’s high-value real estate market, understanding and utilizing a 1031 exchange can significantly enhance your investment returns and long-term wealth. To unlock the tax-deferral benefits of a 1031 exchange in Hawaii, it’s essential to grasp these fundamental principles:

1. Investment or Business Use: Both the property you’re selling (the “relinquished property”) and the property you’re buying (the “replacement property”) must be held for investment purposes or used in a trade or business. 

2. “Like-Kind” Doesn’t Mean Identical: The term “like-kind” refers to the nature of the investment, not its physical characteristics. So, you’re not limited to swapping an apartment building for another apartment building. The IRS allows you to exchange a wide variety of real estate types, as long as they are both held for investment or business use.

3. It Must Be a True Exchange, Not Just a Sale and Reinvestment: The IRS requires a direct exchange of property, facilitated through a Qualified Intermediary (QI). Simply selling a property and then using the cash to buy another one won’t cut it. You can’t receive the money yourself; the QI holds the funds and uses them to acquire the replacement property on your behalf.

Step-by-Step Guide to a Hawaii 1031 Exchange

1. Consult: Before selling your property, speak with your tax and financial advisors to determine if a 1031 exchange is right for you, get a full roadmap of the process and understand your potential benefits. They should also help find a great QI and if they can’t, I work with some great companies in Hawai’i.  

2. Engage a Qualified Intermediary (QI): This step is essential. You need to use a QI to hold the proceeds from the sale. All proceeds must go directly to the QI, as directly receiving funds will invalidate the exchange. 

3. Sell Your Relinquished Property: List and sell the investment property you want to exchange.

4. Identify Replacement Properties (45-Day Rule): After selling your relinquished property, you have 45 days to identify potential replacement properties under IRS rules:

5. 3-Property Rule: Identify up to three properties, regardless of value.

   • Example: Sell for $1M, identify three properties of any price.

   • 200% Rule: Identify multiple properties (more than 3) as long as the total value is no more than 200% of your sold property's price.

     • Example: Sell for $1M, identify 4 properties totaling up to $2M.

   • 95% Rule: If identifying properties exceeding the 200% rule, you must acquire 95% of their total identified value.

     • Example: Identify $3M of properties after selling for $1M; you must purchase at least $2.85M worth.

     • In simpler terms: The 95% rule is saying, “If you’re going to identify a huge number of properties, totaling far more than what you sold your original property for, you better make sure you buy almost all of them to truly demonstrate your intent to reinvest.

6. Complete the Exchange (180-Day Rule): Complete your replacement property purchase within 180 days from the sale date of your relinquished property, including the initial 45-day identification period. Coordinate closely with your QI to ensure compliance.

Hawaii-Specific 1031 Exchange Considerations

• HARPTA and FIRPTA: HARPTA (Hawaii Real Property Tax Act) and FIRPTA (Foreign Investment in Real Property Tax Act) are withholding taxes that may apply to non-resident and foreign sellers, respectively. HARPTA mandates a 7.25% withholding, while FIRPTA can require a 15% withholding. However, a correctly executed 1031 exchange can exempt investors from these withholdings. To gain immediate exemption from HARPTA, promptly file Form N-289. For FIRPTA, obtain a “withholding certificate” from the IRS. Always consult your tax advisor for personalized guidance, especially if you are a non-resident or foreign seller of Hawaii real estate.

• Leasehold Properties: For leasehold properties to qualify for a 1031 exchange, they generally must have at least 30 years remaining on the lease term at the time of closing on the new mortgage. Verify lease details carefully and consult with your CPA to ensure compliance.

• Vacation Rentals: Properties used as short-term vacation rentals (e.g., Airbnb, VRBO) can be excellent for 1031 exchanges but must comply with local short-term rental regulations. Each island has its own regulatory structure for vacation rentals, so be mindful when looking to buy.

  Many homes and condos in allowed vacation rental areas are already operating as vacation rentals and may have an established rental history and existing bookings.

  Contact us for assistance in identifying these opportunities.

Common 1031 Exchange Misconceptions & Pitfalls

• Personal vs. Investment Property: Only investment properties qualify. Personal residences are ineligible. Each property must demonstrate productive use in business or investment.

• Family Occupancy: Allowing family members to occupy the property without paying market-rate rent jeopardizes exchange eligibility. Always document rental income carefully.

• Missed Deadlines: Adhere strictly to the 45-day and 180-day deadlines, as missing these will invalidate your exchange.

• Failing to Use a QI: A Qualified Intermediary is mandatory. Direct handling of funds invalidates the exchange.

• Receiving “Boot”: Receiving non-like-kind assets (like cash) triggers immediate taxes.

Property Types Ideal for Hawaii 1031 Exchanges

• Condominiums (particularly vacation-rental approved)

• Single-family homes in prime locations

• Commercial and industrial real estate (self-storage, retail, office buildings)

• Multifamily properties (luxury apartments, 55+ communities, student housing)

• Vacant land suitable for development

Advanced 1031 Exchange Strategies

• Reverse Exchanges: Purchase your replacement property before selling your current property. This strategy requires substantial liquidity and specialized guidance.

• Improvement Exchanges (Construction Exchanges): Use exchange funds for improvements or new construction on property you already own, enhancing its value. Improvements must be completed within the exchange period.

Tax Planning & Strategic Considerations

Detailed tax implications specific to your situation should always be discussed with a Hawaii-based CPA, who can help optimize your tax outcomes.

Frequently Asked Questions (FAQs)

• What properties qualify for a 1031 exchange in Hawaii?
  Generally, real property held for investment or business purposes qualifies, including condos, single-family homes, commercial buildings, and land.

• Can I exchange Hawaii property for mainland property?
  Yes, exchanges between Hawaii and mainland properties are permissible if the properties are "like-kind."

• What is “boot” in a 1031 exchange, and how can I avoid it?
  “Boot” refers to receiving non-like-kind property, such as cash, triggering immediate taxes. Avoid it by fully reinvesting proceeds into replacement properties of equal or greater value.

• What is “like-kind” property?
  "Like-kind" properties share the same nature or character, even if different in quality. For example, land exchanged for commercial property.

• What are the key 1031 exchange timelines?
  You must identify replacement properties within 45 days of selling your property and complete the purchase within 180 days.

• What happens if deadlines are missed?
  Missing either the 45-day or 180-day deadlines invalidates the exchange, resulting in immediate capital gains taxes.

• Does vacant land qualify for a 1031 exchange?
  Yes, vacant land qualifies if held for investment or business use.

• If I do a 1031 exchange for a Hawaii vacation rental, can I vacation there, and if so, what is the time limit, if any?

  Yes, you can vacation at a Hawaii vacation rental acquired through a 1031 exchange, but there are limits. To maintain the property’s investment status with the IRS, your personal use cannot exceed the greater of 14 days or 10% of the number of days the property is rented at a fair market rate during each 12-month period following the exchange.

  For example, if you rent the property for 200 days in a year, you could use it personally for up to 20 days (10% of 200). Careful documentation is crucial to demonstrate compliance with these rules and to avoid jeopardizing your 1031 exchange benefits. Also, remember the goal of a 1031 Exchange is not just to defer capital gains taxes, but to leverage your assets in a manner that amplifies your investing power within the complex and promising Hawaiian real estate market, so always consider the best return on investment.

Why Partner with Henry?

Henry combines extensive experience, market knowledge, and personalized client attention to support and guide you through your Hawaii 1031 exchange.

Connect with Henry today to discuss your investment objectives and find the right property for your next investment on Hawai’i.