What is a 1031 Exchange?

Internal Revenue Code Section 1031 provides that no gain or loss will be recognized on the exchange of any type of business use or investment property for any other business use or investment property. 1031 Exchanges are not really exchanges in the context of two-party barter. Instead, they are typical sales and purchases that involve the same exact ingredients as any other sale or purchase, without the capital gains. The only real difference is the investor is increasing his selling and buying power by electing to avoid the drain of taxes by using Section 1031 regulations. No other aspects of the transaction are affected.

What is a Tax Deferred Exchange?

A tax deferred exchange ("Exchange") is simply a method by which a property owner may trade one property for another without having to pay any federal income taxes on the transaction.

In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property But in an Exchange, some or all of the tax on the transaction is deferred until some time in the future, usually until the newly acquired property is sold. These Exchanges are sometimes called "tax free Exchanges", because the Exchange transaction itself is only partially taxed or not taxed at all.

Exchanges are granted authority under Section 1031 of the Internal Revenue Code ("IRC 1031") and the Regulations promulgated thereunder. When an Exchange is conducted in accordance with the Code and the Regulations, the tax on the gain which is realized by virtue of the sale of the old property will be deferred, (not recognized) until such time as the property acquired in the Exchange is sold or otherwise disposed of in a taxable transaction.

In an Exchange, a property owner simply transfers the old property and receives the new property. However, the Exchange must be structured in such a way that it is, in fact, an Exchange of one property for another, rather than the sale of one property and the purchase of another. A taxpayer is deemed to have sold property in a taxable transaction if the rights and interests in the property are conveyed and the taxpayer is in actual or constructive receipt of the proceeds. Consequently, a taxpayer who transfers title to property to the buyer and walks the proceeds across the street to purchase the new property, has sold property in a taxable transaction and will not be afforded the benefits of an Exchange.

The taxpayer may avoid the taxable le sale and purchase and qualify for Exchange treatment if, prior to the sale of the old property, the taxpayer enters into an Exchange agreement with a ("Qualified Intermediary"), a fourth party principal who helps to ensure that the Exchange is structured properly and meets all of the requirements of the Code and the Regulations, and pursuant to the Exchange agreement assigns all of his or her rights in and to the sale agreement to the Intermediary.

Requirements of a Tax Deferred Exchange

Although many investors mistakenly believe an exchange is simply a "swap" of properties, most exchanges completed are variation of what is called a "delayed" exchange. In a delayed exchange under Section 1031, the property currently owned is called the "relinquished" property and must be exchanged for like-kind "replacement" property. The IRS allows 180 days between the sale of the relinquished property and the purchase of the replacement property. There are a number of requirements which need to be met to qualify for tax deferral under the tax code.

Requirement #1: Both the "relinquished" and the "replacement" properties must be used in a business or held for investment. The IRS uses the term "like-kind" to describe the type of properties that qualify. Any property held for investment can be exchanges for any other "like-kind" property held for investment. This definition covers a vast variety of developed and undeveloped real estate. Properties which are not "like-kind" are an investor's primary residence or property "held for sale". The relinquished and replacement properties need not have identical function.

Requirement #2: The IRS requires an investor to identify the replacement property(s) within 45 days from closing on the sale of a relinquished property. The 45 Day Identification Period begins on the closing date, and the replacement property(s) must be identified in a letter signed by the Exchanger and received by the Qualified Intermediary.

Exchangers have a number of ways to properly identify properties. They may identify up to three target properties without regard to their total fair market value (Three Property Rule). Alternatively, they can identify an unlimited number of replacement properties if the total fair market value of all properties is not more than twice the value of the property sold (200% Rule). As a final option, an Exchanger can break both of these rules if they acquire 95% of the aggregate fair market value of all identified replacement properties.

Requirement #3: Close on the Replacement property by the earliest of either: 180 calendar days after closing the sale of the relinquished property or the due date for filling the tax return for the year in which the relinquish property was sold (unless an automatic filing-extension has been obtained).

Example: If an Exchanger closes on the relinquished property on December 27, the 180 day period will end April 15 (Tax Day). In this case, they would have to close on the replacement property or request a filing extension by April 15. Exchangers may choose to close both transactions within a shorter period of time, thereby avoiding the potential hardship of the 45/180 day time limit.

Requirement #4: The most common exchange format, the delayed exchange, requires investors to work with an IRS-approved middleman called a "Qualified Intermediary". The Qualified Intermediary documents the exchange by preparing the necessary paperwork (Exchange Agreement) and holds the proceeds of the exchange in escrow on behalf of the exchanger.

Note: To defer capital gains tax, an exchanger must buy a property or properties of equal or greater value (not including closing costs), reinvesting all net proceeds from the sale of the relinquished property. Any funds not reinvested, or any reduction in debit liabilities not made up for with additional cash from the exchanger, is considered "boot" and is taxable.

Parties in an 1031 exchange

Exchanger: The Exchanger is the taxpayer who is electing to defer the capital gains by effecting a 1031 Exchange.

Seller: The seller is the person who owns the property the Exchanger wishes to acquire as a replacement property.

Buyer: The buyer is the person who wants to purchase the property the Exchanger is selling.

Intermediary: For delayed exchanges the use of a qualified Intermediary is required by the regulations of Section 1031. The role of the Intermediary acts as a middleman in both the sale and purchase transactions, holding the proceeds from the sale in escrow until the purchase occurs.

Properties in an 1031 exchange

The Relinquished Property: The relinquished property is the business use or investment property the Exchanger owns and wants to sell via the 1031 Exchange.

The Replacement Property: The replacement property is the business use or investment property the Exchanger wants to acquire to complete the 1031 Exchange.

There can be more than one of each of the relinquished and replacement properties. For example, an Exchanger can sell three small properties and purchase one large property or sell one large property and acquire four smaller ones. An Exchanger does not have to purchase the same type of property. For example, he can sell a storage facility and acquire an apartment building or sell a raw piece of land and acquire a shopping center.

Important: The above rules can be subject to change by regulatory entities. It is recommended to also involve your CPA or tax advisor for advice on selling vs. exchanging.