1031 Exchange

What is a 1031 Exchange?

Individuals and companies who sell appreciated property (real estate or personal property) are subject to capital gains tax under the Internal Revenue Code. Under IRS’s 1031 Exchange rules, however, an exchange is not considered to be a sale and no capital gain is recognized or subject to tax. The basis of the relinquished property becomes the basis of the replacement property and tax is deferred until such time as the replacement property is “sold”. If the replacement property is later exchanged for another replacement property (not “sold”), tax is also deferred. So, as long as your business, rental or investment properties are disposed of in 1031 Exchanges, the capital gains tax will continue to be deferred.

1031 Exchanges are sometimes referred to as “Like-Kind Exchanges”, “Starker Exchanges”, “Tax Free Exchanges” and “Delayed Exchanges”, but they all mean the same thing — if you comply with the rules and are willing to reinvest in “like kind” property, you can dispose of your appreciated property and reinvest all of your proceeds without paying anything to the IRS thereby keeping more cash working (and property earning income and appreciating) than you would if you paid the tax each time you dispose of appreciated income or investment property. If you (the “Exchangor”) die owning the last of a series of 1031 Exchange properties, the property will normally receive a “stepped-up basis” thereby causing the entire built-up capital gains tax to be permanently avoided.

What does a Qualified 1031 Exchange Intermediary do?

A Qualified 1031 Exchange Intermediary prepares necessary documents including the Exchange Agreement, and enters into the Exchange Agreement with the Exchangor. Then, as required by the Exchange Agreement, the Exchange Intermediary acquires the relinquished property from the Exchangor, transfers the relinquished property to the buyer, acquires the replacement property from the seller and transfers the replacement property to the Exchangor to complete the exchange. Although both the relinquished property contract and the replacement property contract are assigned to the Exchange Intermediary, it is not necessary for the Exchange Intermediary to actually take title to either property because the IRS rules allow direct deeding of the relinquished property from the Exchangor to the buyer and direct deeding of the replacement property from the seller to the Exchangor to complete the exchange. Between the closing of the relinquished property and the closing of the replacement property (which can be as much as 180 days apart), the Exchange Intermediary normally holds the proceeds from the relinquished property in escrow so that the Exchangor does not violate the rule against actual or constructive receipt of those funds before they are reinvested in the replacement property.

Where Can Relinquished And Replacement Properties Be Located?

Anywhere.

Who Can Do A 1031 Exchange?

United States citizens (whether individuals or domestic companies) who would otherwise be subject to capital gains tax under the Internal Revenue Code can defer taxes by participating in 1031 Exchanges. Remember, however, that foreign persons (non-resident aliens) and foreign companies who own income/investment property in the United States may also take advantage of 1031 Exchange tax deferral. In other words, you do not need to be a United States citizen or have a “green card” in order to take advantage of exchange treatment for your income and investment properties, so long as they are located in the United States.

Types Of Exchanges

There are simultaneous exchanges in which the relinquished property and replacement properties are transferred on the same day to complete the exchange. But, this does not happen very often. Usually, exchanges are delayed so that, after the relinquished property is transferred to a buyer, the Exchangor takes up to 45 days to identify replacement property (up to three properties can be identified even if you only expect to purchase one, unless the “200 percent rule” applies), and then the Exchangor has 180 days after the relinquished property closing (or the due date of the Exchangor’s tax return including all extensions if such date would be earlier than 180 days) to close upon at least one of the identified properties. IRS “safe harbor” rules for such exchanges have been in effect since 1991.

There are also reverse exchanges where the Exchangor needs to close on the replacement property before he has sold the relinquished property. This can be done by the Exchange Intermediary “warehousing” (taking title to the property temporarily so the Exchangor does not own both the relinquished property and the replacement property at the same time). Either the relinquished property or the replacement property can be warehoused, depending on the circumstances. Effective September 15, 2000, IRS issued Rev. Proc. 2000-37 which provides “safe harbor” rules for reverse exchanges.

Also, there are construction (build-to-suit) exchanges where the Exchangor needs to have a building constructed on vacant property before taking title in order to complete an exchange where the relinquished property included a building. This kind of exchange is the most complicated.