Save Money: Defer Taxes with a 1031 Exchange

What is a 1031 Exchange? It is a procedure established by the Internal Revenue Code (IRC Section 1031) for handling real property "like kind" transactions. It involves the sale and subsequent purchase of real property, which includes, but is not limited to, single and multi-family residential property, office, industrial and retail commercial property, hotels, farmlands, leases of 30 years or more, quarries, raw land and oil fields. Any real property can be exchanged for the other.

What are the benefits of a 1031 exchange?

• Deferred capital gains tax. Pursuant to Internal Revenue Code Section 1031 corporate, institutional, and individual taxpayers are allowed to defer Federal and, in most cases, state capital gain taxes, when they sell qualified real or personal property and reinvest in replacement property of "like kind".
• Improved rate of return on assets by reinvesting a 100% sales proceeds due to tax-deferred treatment.
• Increased annual income tax deductions by exchanging low cost basis assets or non-depreciating assets, such as raw land, for higher cost basis assets.
• Increased cash flow by trading a non-income producing asset for an income-producing asset.

How does a 1031 exchange work?

There are two main forms of 1031 exchanges and these are referred to as forwards and reverses. A sub-category is a build-to-suit, which can be either a forward or a reverse exchange.

Note: Internal Revenue Code Section 1031 (tax deferred exchanges) are complex transactions. When considering this type of transaction it is a good idea to consult with a tax, financial and/or legal advisor.

Forward 1031 exchanges are the most common structure for a tax deferred "like kind" exchange. This transaction first involves the sale of the exchanger's property and then the subsequent acquisition of a replacement property. Both the sale and purchase can happen at the same time. However, many people choose for the 1031 exchange to be structured so that the sale of property happens first, and the acquisition of the replacement property happens second. This gives them more time to locate replacement property.

It is required that the exchanger identifies the replacement property within 45 calendar days after the transfer of the relinquished property. Up to three properties, regardless of the aggregate fair market value, can be identified. The exchanger also can identify more than three properties if: a) the total market value of relinquished properties does not exceed 200% of the fair market value of the relinquished property; or b) the total fair market value of the replacement properties equals 95% of the total fair market valued of the replacement properties identified.

Reverse exchanges are more complex and costly to structure, but provide the taxpayer with more flexibility than forward exchanges. These are useful when replacement properties are difficult to locate. In this scenario, taxpayers can acquire the replacement property first, and then subsequently sell their relinquished property. This eliminates the taxpayer's risk of not being able to identify and acquire a suitable replacement property within the mandatory 1031 exchange timeline.

The two main parts of a reverse exchange involve the "parking" transaction and the "1031 exchange" transaction. These can be structured in different ways to accommodate the taxpayer's needs. In a reverse Exchange First Structure, the taxpayer enters into a "like kind" exchange transaction where they sell the relinquished property to the Exchange Accommodation Titleholder, who "parks", or holds title, for the relinquished property. The taxpayer simultaneously acquires and receives title for the replacement property from the seller. Once the relinquished property is sold, it is structured as a simple sale transaction between the Exchange Accommodation Titleholder and the buyer. The transaction is structured where the actual "like kind" exchange is the first step and the parking arrangement is the last step (exchange first).

In an Exchange Last Structure the Exchange Accommodator Titleholder acquires the replacement property from the seller and "parks" or holds title to the replacement property until the taxpayer can dispose of the relinquished property.

The replacement property (ies) must be acquired on or before 180 calendar days from the transfer of the relinquished property (ies) or the due date of the exchanger's Federal income tax return (including extensions) for the year the relinquished property transaction closed (which ever is earlier).

Capital Gains Estimator

This information is designed to provide accurate and authoritative information in regard to the subject matter covered. It is given with the understanding that the author is not engaged in rendering legal service. If legal advice or other expert assistance is required, the services of a competent legal person should be sought.