Introduction to 1031 Exchanges

Introduction to 1031 Exchanges

1031 exchanges are s a great way for an investor to build wealth and defer taxes. A 1031 tax deferred exchange is a simple yet strategic way of selling one property and purchasing another qualifying property within a specific time frame.

A 1031 exchange is not so different than a straight sell-purchase scenario on the surface. Beneath the surface, an exchange is different because the entire transaction is recorded as an exchange and not a sale. And it is this simple distinction which ultimately allows the taxpayer to qualify for deferred gain treatment. So essentially, sales are taxable and exchanges are not.

Why exchange?

Any property owner who expects to acquire replacement property subsequent to the sale of his existing property should consider a 1031 exchange. After all, why pay capital gain taxes (the amounts of which can exceed 20-30%, depending on the appropriate combined federal and state tax rates)? In other words, when purchasing replacement property with the benefit of a 1031 exchange your buying power is dramatically increased.

Basic 1031 Exchange Rules

1.

The purchase price of the replacement property should be equal to or greater than the net sales price of the relinquished property.

2.

All equity received from the sale of the relinquished property should be used to acquire the replacement property.

3.

If you have debt on that is paid off on the relinquished property sale, it is recommended you obtain equal or greater debt on your replacement property or bring in cash from a pre-taxed source to avoid “Debt Relief”.

The above rules are guidelines for a totally tax-deferred exchange. If you don't meet one of the three, you may be subject to tax on the difference, and still have a partial tax-deferred exchange on the rest.

4.

The property sold (relinquished) and purchased (replacement) in the exchange must both meet the IRS Like-Kind Property definition which is “any property held for productive use in a trade or business or held for investment purposes”. (See our page on Like-Kind Property for more information.)

5.

Seller/Exchanger can not have “Constructive Receipt” of the sale proceeds. A Qualified Intermediary must be used to safeguard and direct the funds during the exchange.

Examples of a 1031 exchange

An investor buys a strip mall (a commercial property) for $200,000. After six years he could sell the property for $250,000. This would result in a gain of $50,000 on which the investor would have to pay a capital gains tax, but, if he invests the proceeds from the $250,000 sale in another property, then he would not have to pay any taxes on the gain at that time.

An owner of a detached house on 3 acres is transferred by his employer to another state. Rather than selling the home, which will no longer be his personal residence, he chooses to rent it out for a period of time. After ten years, he decides that he wants to sell it but, at the same time, he has a grown son who will be going to college in yet another state. He decides that he wants to buy an apartment building in the college town for the son and other students to rent while they are in school. His house has appreciated from $200,000 to $300,000. Therefore, he arranges for an IRC 1031 Exchange, and buys the new property, thus avoiding the capital gain at that time.

How a 1031 exchange works

The following sequence represents the order of steps in a typical 1031 exchange.

1.

An investor decides to sell investment property and do a 1031 exchange. He contacts a qualified intermediary.

2.

The investment property is put on the market.

3.

An offer to purchase the investment property is accepted and signed by the intermediary. The Seller/Exchanger then opens an order with the Qualified Intermediary (An order can be opened at anytime prior to the actual sale/closing of the property. This however is the most opportune time).

4.

Escrow for the sale is opened, and a preliminary title report is produced.

5.

The intermediary sends required exchange documents to the escrow closer for signing at property closing.

6.

Escrow closes and Sale Proceeds are not given to the seller/exchanger, they are sent directly to the Qualified Intermediary to comply with the Safe Harbors the IRS requires.

7.

Within the first 45 days after this close of escrow on the sale of the relinquished property, the investor identifies replacement properties as required by law. This is known as the "Identification Period".

8.

Within 180 days after the close of escrow on the sale of the relinquished property, the investor closes on at least one of the replacement properties which he has identified. This is called the "Exchange Period". This completes the exchange. Keep in mind the 45 day Identification Period and the 180 day Exchange Period run concurrently. (ie. after the 45 day Identification Period, you only have 135 days left in your Exchange Period.