Everything You Always Wanted to Know About a Section 1031 Tax Deferred Exchange But Were Afraid to Ask

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Everything You Always Wanted to Know About a Section 1031 Tax Deferred Exchange But Were Afraid to Ask

Everything You Always Wanted To Know About A Section 1031 Tax-Deferred Exchange But Were Afraid To Ask

A Section 1031 exchange provides for the tax-deferred treatment of capital gains on the sale of qualified appreciated real estate. This type of transaction, named for the Internal Revenue Code Section in which it appears, is an increasingly common tool used by real estate investors to preserve and build real estate wealth. In the simplest terms, when a real estate investor sells qualified real estate and uses the proceeds to purchase ‘like-kind’ business or investment property, the IRS permits the capital gain that would be realized on the sale to be deferred. For the Section 1031 exchange to be valid and have the intended tax sheltering effect, complex rules and time frames must be satisfied and followed.

The concept of property exchange is not a new one. It usually involved a two-party direct exchange, in which the buyer and seller would “swap” their properties, but was uncommon since it was difficult to find two owners who wanted each other’s property and did not take into account any necessary financing. Also, if the transactions did not occur simultaneously there were serious tax consequences. How then to dispose of appreciated property to finance the acquisition of new property and avoid taxable gains that would substantially reduce your equity? This dilemma was solved on April 25, 1991 when the IRS issued Reg. 1.1031 (k)-1. It provided the mechanism to allow a time lag between the “buy” and the “sell” and created the position of “Qualified Intermediary” to hold the proceeds in escrow and facilitate the transaction. The entire transfer process can now take place without the buyer of your existing property or the seller of your new property getting involved.

Anyone who owns what is called “qualifying property” that is appreciated should always evaluate whether a Section 1031 exchange would be advantageous whenever divesting or acquiring property. Although many real estate investors are intimidated by the many special terms and strict requirements that are involved in a Section 1031 exchange, this should not discourage their participation. Rather, as in most specialized transactions today, it is only necessary for the layperson to have a basic understanding of how it works, leaving the details to the appropriate professionals. I have set forth below some important definitions and a the basic ingredients of a successful Section 1031 Exchange. Since the scope of this article is limited, anyone considering a Sec.1031 exchange should have it professionally evaluated and handled.

Definitions you need to know:

Qualifying Property
: generally any real property that is held for business use (Section 1231 property) or for investment (Sec.1221 property) will qualify. NOT property held for personal use or primarily for sale (dealer property). Examples are: owner occupied business property, commercial rental income property, single or multi-family rental income property, and raw land.

Like-Kind Property
: this is a federal tax term that defines types of real estate; for Sec. 1031 purposes all real estate is like kind to other real estate so long as it is located within any of the 50 states or the U.S. Virgin Islands, and properly ‘identified’, see below.

Relinquished Property
: the qualified property that was transferred (sold)

Replacement Property
: the qualified property that was received (bought with the proceeds)

Qualified Intermediary
: a person or company who, for a fee, facilitates the process by entering into an agreement with you for the exchange of properties.

Identification
: the Replacement Property must be identified in no more than 45 calendar days from the date of sale of the Relinquished Property by written notice to the exchanger.

Exchange period
: the purchase of the Replacement Property must be completed no later than 180 calendar days from the date of sale of the Relinquished Property.

To review, a Section 1031 exchange occurs when a Qualified Intermediary exchanges your Qualifying, Like-Kind Relinquished Property for your properly identified Qualifying Like-Kind Replacement Property that has an equal or greater fair market value. When properly done, the entire proceeds of the sale of the Relinquished Property are invested in the Replacement Property and any capital gains tax that would have been recognized on the sale are deferred. The Qualified Intermediary is needed so that at no time does the Seller have access to, or receipt of the proceeds of the sale which would trigger a tax consequence. Under a 1031, you are able to buy and sell in the order that is convenient for all the parties. The most common one is the delayed exchange, or “Starker Exchange” in which you have up to 180 days to complete the purchase of the Replacement Property. Less common, but allowed since September 15, 2000, is the reverse exchange, where the Replacement Property is purchased prior to the sale of the Relinquished Property. It is also possible to acquire multiple Replacement Properties during a single exchange using either the 3-Property Rule, the 200 Percent Rule, or the 95 percent rule. And there is no limit to the number of times an investor can participate in a Section 1031 exchange.

There are some very important pitfalls that must be avoided in order to accomplish a successful exchange. Of paramount importance is adherence to all the time frames and deadlines. All proceeds from the sale must be invested in the Replacement Property and the amount of the mortgage (if any) used to buy the Replacement Property cannot be less than the amount of the mortgage (if any) that was paid off during the sale of the Relinquished Property. Further, the seller of the Relinquished Property must be exactly the same as the buyer of the Replacement Property. Finally, it is very important to be aware of the basis not only of the Relinquished Property, but also of the Replacement Property so that the transaction can be planned to take the most advantage of the ability to defer the capital gains.

Although it may seem that a Section 1031 exchange is a complex and convoluted transaction, in reality it is simple and elegant and usually none of the parties to either the purchase or the sale or unduly inconvenienced or even aware that they are involved.

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