1031 Basics

What is a 1031 Exchange?

The tax-deferred exchange as defined in Section 1031 of the Internal Revenue Code of 1986 offers taxpayers the opportunity to build wealth and save taxes. A tax-deferred exchange is a transaction in which an owner of real property, held for investment, sells one property and acquires another like-kind replacement property without paying any federal income taxes on the transaction. When properly done, the tax consequence does not disappear, but is moved forward into the new property. By completing an exchange, the investor can dispose of their investment property, use all of the equity to acquire replacement investment property, defer the capital gain tax that would ordinarily be paid and leverage all of their equity into the replacement property (properties). To defer the capital gain tax, the exchanger must acquire “like-kind” replacement property and the exchanger can’t receive cash or other benefits.

In any exchange, the investor must enter into the exchange transaction prior to the close of the relinquished property. The investor and the Qualified Intermediary (QI) enter into an Exchange Agreement, which required that the QI acquire the relinquished property from the investor and transfer it to the buyer. The cash or other proceeds from the transaction are assigned to the QI and should be held by the QI in a separate secured account. The exchange funds are then used by the QI to purchase the replacement property for the investor. The investor is not allowed to have direct control or access to his funds during the transaction.

Advantages or Reasons to Exchange

The most common objective of exchanging is to avoid paying the taxes associated with selling property. Even more importantly, the investor will keep 100% of his equity working, rather than giving a portion to the IRS.

Many investors will use a 1031 exchange to move their real estate investment from one geographic location to another. Often investors will want to do this when relocating due to a job transfer or retirement. Given the climate of the current national real estate market, many investors are exchanging their California, Hawaii, Nevada, New York, Connecticut, New Jersey and Florida properties for the safer haven of North Carolina.

Some investors will use a 1031 exchange as a way of selling a property with no current income or one with a small return and replacing it with one that provides a better cash flow. Underperforming properties can be exchanged for better performing properties. As an example, an investor may choose to sell his undeveloped land through a tax-deferred exchange and acquire an income producing property that can produce cash each month.

Some investors will use a 1031 as a means of taking advantage of an opportunity to invest in a property that has a greater appreciation potential than their existing investment.

Additional reasons to consider an exchange include:

1. Being tired of residential rentals and wanting commercial or vacant land
2. Wanting to sell a fully depreciated property and buying a more valuable property and thus creating a new tax shelter
3. Wanting to leverage up his or her investments
4. Wanting to defer payment of tax liability to take advantage of the "time value of money”
5. Wanting to rearrange holding in anticipation of death

IRS Classifications of Real Estate (only 4 Categories)

1. Principal residence (Including second homes and time-shares)
   Tax-free exchanges are NOT allowed.
2. Inventory property held primarily for sale.
   Example: a dealer/developer purchases 100 acres and builds 200 new homes. This is his inventory. The owner is considered a dealer in real estate; a dealer is someone who makes his or her living from a certain activity, in this case the development of real estate. The property is classified as inventory and a tax-free exchange is NOT allowed.
3. Property held for the productive use in trade or business
   Example: Many different types of entities may own property for trade or business, for example, single persons, a husband and wife, partnerships, limited liability companies, corporations and trusts. Tax-free exchanges ARE allowed by the IRS.
4. Investment property
   Example: Investment property also may be owned by single persons, a husband and wife, partnerships, limited liability companies, corporations, and trusts. An investment of 200 acres of land, a lot at the beach, an apartment complex, a single-family home, or an industrial building are all examples of investment properties. Tax-free exchanges ARE allowed by the IRS.

Types of Exchanges

Simultaneous Exchange
In a simultaneous exchange, both properties close the same day. An important consideration is that all mortgages have to be factored into the equation. If a mortgage is paid off on the sale of a relinquished property but not replaced as a mortgage on the replacement property, tax liability is likely to result (this is an example of “boot”).

100 Percent Tax-Free Exchange
If you want the deal to be totally tax free you need to:

1. Buy up
2. Mortgage up and
3. Spend all the money.

If you purchase a replacement property more expensive than the sales price of the relinquished property and end up with at least as big a mortgage on the replacement property as you had on the relinquished property and spend all the money (proceeds of the sale) that came out of the relinquished property, there will be absolutely NO TAX LIABILITY.

Delayed Exchanges
Multiple court cases of Starker vs. IRS marked the successful arrival of the delayed exchange concept. In the delayed exchange, “like-kind” property must be designated within 45 days of the sale closing. The replacement property absolutely must be closed by the 180th day. Once the replacement property has been located, the QI purchases it and immediately trades the property to the exchanger. The process begins when the Exchange Agreement is signed and the relinquished property is transferred to the QI with all necessary documentation of the exchange. The property is then sold to the buyer and the cash proceeds are deposited into a segregated account held by the QI. The process continues when a purchase agreement is signed with a seller. The QI is assigned this contract and completes the exchange when the replacement property is transferred to the taxpayer pursuant to the Exchange Agreement.

Reverse Exchanges or Reverse Starker Exchange
Situations sometimes make it necessary to acquire the replacement property before closing on the relinquished property. This can be accomplished through a reverse exchange which is now officially sanctioned by the IRS when properly structured.