What is a 1031 Tax deferred Exchange?

A 1031 tax deferred exchange is an exchange in which capital gains tax deferral is available to real estate owners who sell their investment, rental or business real estate, and reinvest the net proceeds in other real estate. Real Estate held for these purposes are called "like-kind or 1031 properties".

Property owners may sell like-kind properties and defer taxes on the sale's profits by meeting the requirements of Internal Revenue Code (IRC) 1031 exchange. The purpose of the 1031 Exchange is to allow sellers of like-kind property to buy replacement property of like-kind within a specific time period and defer taxes.

HERE'S AN EXAMPLE

Let's say you have owned a property for a number of years for which you paid $400,000. You now owe $320,000 on the mortgage and have depreciated $150,000 over the time period for which you owned the property. Now you have a buyer for $1,000,000. If you were to pay the tax on completion of the sale, you would pay approximately $150,000 in capital gains taxes (20% Federal and 5% State) in addition, you would pay $37,500 in recapture of the depreciation taken. You would be left with $492,500 to reinvest. There is quite a difference if you can reinvest the entire $680,000 of equity; you have $187,500 additional to invest as a result of the tax deferral. This is what a 1031 exchange can do for investors.

	Straight Sale	1031 Exchange
Sale Price:	$1,000,000.00	$1,000,000.00
Less: Mortgage Balance	$320,000.00	$320,000.00
Equity	$680,000.00	$680,000.00
Less: Capital Gains Tax	$150,000.00	Tax Deferred
Equity Balance	$430,000.00	$680,000.00
Less: Tax on Recapture	$37,500.00	Tax Deferred
Balance Available to Reinvest	$492,500.00	$680,000.00

WHO QUALIFIES?

To qualify for a Tax Deferred Exchange, the exchanger must exchange the original investment property for a "like kind" replacement property or properties. It is at this point that many investors become confused. We often hear the question: "Does 'like kind' mean that I must trade my apartment building for another apartment building or must I trade my commercial office building for another commercial office building?"

When the tax code talks about "like kind" property, the meaning is quite simple. An investor can trade any type of investment property or property held for trade or business, for any other type of investment property or property held for trade or business. This means that an investor can trade an apartment building for a commercial building or for a working farm or for an industrial building etc. What an investor cannot do is trade investment property for a personal residence and vice versa. It is however possible to convert a personal residence to investment property by renting it and then at a later date, exchanging it for investment property.

QUESTION: "WHY?"

In addition to the rule that exchangers must trade for "like kind" property or properties, it is important to look at the language regarding 1031 Tax Deferred Exchanges found in the Internal Revenue Code, which says, "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held for productive use in a trade or business or for investment." In other words, capital gains taxes can be deferred if all cash proceeds from the original property are used to acquire a replacement property and the exchanger ends up with an equal or greater amount of debt on the replacement property.

TYPES OF IRC 1031 TAX-DEFERRED EXHANGES

The Simultaneous Exchange

This simply refers to an exchange wherein the relinquished property and the property to be acquired have escrows that are closed simultaneously. It is extremely important in this circumstance that each closing is contingent upon the other closing to maintain the integrity of the exchange. As anyone who has ever been involved in a complex real estate transaction knows, it is difficult to predict with certainty exactly when a transaction will close. It is for this reason that the Starker Delayed Exchange has come into favor with real estate investors.

The Delayed Exchange

As was stated above, because of the inherent problems associated with simultaneous closings and the dangers of violating the rules of IRC 1031, more and more real estate investors are using "Starker Delayed" exchanges as the method of choice for completing tax deferred exchanges. The rules for using delayed exchanges are to be found in the amendments to the tax code that Congress wrote into the 1984 Tax Reform Act.

The Rules are as Follows:

The exchanger has a total of 45 days from the closing of the property that is disposed of to identify up to three potential replacement properties.
Or the exchanger can identify any number of properties so long as their combined fair market value does not exceed 200% of the value of the property being disposed of.
The 95% exception rule, states that neither of the first two rules apply if 95% of the value of all of the properties identified are actually acquired.
The exchanger has a total of 180 days from the close of the property that was relinquished (sold) to close on the replacement property. Remember that the rule is not six months, but 180 days.

The Reverse Exchange

The Internal Revenue Service has recently issued Revenue Procedure which allows an exchanger to complete a Reverse Exchange. A Reverse Exchange allows the exchanger to acquire property before the exchanger has sold the property that he would like to relinquish in the Exchange. This gives the Exchanger the possibility of making sure that the up-leg property definitely fits his requirements before selling his old property.

When using the delayed exchange method, it is necessary to engage the services of a competent and reliable exchange intermediary. The intermediary will hold the proceeds of the relinquished property in trust for the exchanger and upon the instruction of the exchanger, acquire one or more of the named properties and assist in the closing of the replacement property.