What is 1031 Exchange?

Internal Revenue Code Section 1031 is a powerful tool for deferring capital gains tax on commercial/investment transactions. A 1031 Tax Deferral permits a taxpayer to reinvest the proceeds from the sale of a property held for investment or business purposes into another investment or business property, and defer capital gains taxes that would otherwise be due on the initial sale.

The most common type of exchange is the “Forward Delay Exchange” where the taxpayer sells business or investment property and acquires Replacement Property of equal or greater value within 180 days. The use of a Qualified Intermediary's Services, is a safe harbor requirement to facilitate a valid tax deferred exchange.

Reasons to Exchange

In addition to deferring taxes and reinvesting savings, there are many other advantages to exchanging investment properties, including:

  • Leverage: Leverage your equity to acquire a more valuable property or properties.

  • Diversification: Spread your equity to acquire a more valuable property or properties.

  • Consolidation: Consolidate the equity among properties varying in value, type or location.

  • Cash Flow: Move equity from a low income producing property (like raw land) to a higher income producing property such as retail or industrial.

  • Management Relief: Trade property with excessive maintenance and overhead for managed property.

  • Increased Depreciation: Change property types to take maximum advantage of available depreciation.

  • Estate Planning: Turn tax deferral into tax savings by including 1031 strategies in your estate plan.

Tax Deferral Under § 1031:

The most commonly used tax-deferral strategy is the Forward Delayed Exchange. In a typical Delayed Exchange, the taxpayer sells a business or investment property and acquires replacement property of equal or greater value within 180 days. The use of a Qualified Intermediary is required to facilitate a valid tax-deferred exchange.

Before you begin the exchange process, be sure to consult with your tax or financial advisor to insure that a 1031 exchange is right for you. Then, contact a Qualified Intermediary to help you complete the exchange process in three easy steps:

  • Step One: Sale of the Relinquished Property. Before the sale of the first property the Exchanger must add certain facilitating language into the Exchanger's Contract for Sale and complete the additional documentation prepared by the Qualified Intermediary. On closing, the closing proceeds are delivered directly to the Qualified Intermediary.

  • Step Two: Identification of the Replacement Property. The Exchanger must identify the property to be purchased (generally called the "Replacement Property") within 45 days following the sale of the Relinquished Property. The taxpayer may generally identify up to three properties as a potential Replacement Property, or more subject to certain restrictions.

  • Step Three: Purchase of the Replacement Property. The Exchanger must obtain the Replacement Property within 180 days following the sale of the Relinquished Property, which must be identified property, subject to the rules listed above. On closing, the closing proceeds are paid directly by the Qualified Intermediary, and the Exchanger receives the Deed to the Replacement Property.

Types of Exchanges:

A Simultaneous Exchange is a deal that is extremely short-lived lasting only one day. The closing of the relinquished property and the closing of the replacement are executed concurrently. While in a Delayed Exchange the replacement property is bought subsequent to the closing of the relinquished property, a Reverse Exchange is just the opposite. The replacement is purchased prior to the selling of the relinquished; the Qualified Intermediary holds title until the taxpayer has sold the property. An Improvement Exchange is similar to the Reverse Exchange. The taxpayer acquires the replacement property for the purpose of making arrangements for construction before it is classified as a replacement. The Qualified Intermediary takes title of the land for the time being. Nonetheless, personal property must be exchanged for its mirror-image equivalent.

1031 Exchange Requirements:

Taxes on capital loss/gain may be unwarranted, if, for instance, one is qualified for the Delayed Exchange. Accordingly, there are several basic guidelines that place a transaction within §1031:

  1. The properties must be analogous—of "like-kind."Although this may seem like a predicament, the IRS is broadminded when evaluating "real property" transactions. Thus, as long as commercial property is exchanged, it will generally be deemed adequate to satisfy the "like-kind" clause. Moreover, office facilities and equipment must be exchanged for their equivalent.
  2. There must be a genuine replacement. A mere sale is unacceptable; it will take the entire transaction outside the boundaries of §1031.

  3. The property exchanged must be employed for commercial purposes: business and investment. The replacement property must be one that caters to the taxpayer's trade. Residential property does not apply to the Delayed Exchange (1031).

  4. Although 1031's main purpose is to benefit those involved in particular real estate transactions, the gratuity is restricted. An exchanger must act promptly because a lapse of time will invalidate the tax deferral. Pay close attention to the specified deadlines. The timing requirements are discussed within the three steps necessary to execute a Delayed Exchange.
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