What is a 1031 Tax-Deferred Exchange?

It’s a great way for an investor to build wealth and defer taxes that would otherwise be due on a straight sale.

The Internal Revenue Code states that neither gain nor loss is recognized if a property held for investment or productive use in a trade or business is exchanged for "like-kind" property.

The taxpayer may avoid the taxable sale and purchase and qualify for Exchange treatment if, prior to the sale of the old property, the taxpayer enters into an Exchange Agreement with a "Qualified Intermediately" who structures the exchange transactions properly to meet all of the requirements of the Code and the Regulations.

IRS Guidelines

There are 3 Basic Guidelines set by the IRS for total tax deferred treatment.

1. The Replacement property purchase price should be equal to or greater than the relinquished property sales price.
2. The Replacement property debt (mortgage) should be equal to or greater than the Relinquished property debt (no "Debt Relief").
3. All net proceeds should be used to acquire the Replacement property.
   
   

Like-Kind Property

Like-kind refers to the nature of the property.  The IRS definition of Like-Kind is "any property held for productive use in a trade or business or held for investment purposes".

You can exchange any combination of the below types of real estate:

Raw/Vacant Land
Multi Family Rentals
Single Family Rental
Commercial
Shopping Center
30 year or more leasehold

An example of Like-Kind property would be: Vacant Land for a Multi Family Rental.

Property ineligible under 1031 guidelines:

Primary residence
Partnership interests
Money
Stock, Bonds or Notes

Delayed Exchange Time Frame

The most common exchange today is the delayed exchange.
 
There are two very important time frames to keep in mind.  The 45-day identification period and the 180-day exchange period.
 
You have 45 days from the recording of the deed to identify your possible replacement properties.  You have a total of 180 days to close on your replacement properties.  No exceptions or extensions.

Identifying Replacement Property

When Identifying Replacement Property in your exchange, you have two choices. You can use the Three Property Rule or the 200% Rule.

 The Three Property Rule allows you to identify up to 3 properties. You can purchase one, two or all three of those properties to complete your exchange. If you wish to purchase more than three properties, you will need to identify under the 200% Rule.

The 200% Rule is set up for you to identify as many replacement properties as you wish as long as the aggregate fair market value of all the identified properties does not exceed 200% of the relinquished property value. You may purchase any combination of these identified properties keeping in mind to be totally tax deferred, you should purchase properties equal or greater in value to your relinquished property. 

An exception to this rule is called the 95% rule. You can choose to identify more than 200% , but if you do, you must purchase 95% of the values you identified or your entire exchange fails.

Exchange Eligibility

Section 1031 of the IRS code is written for owners of property held primarily for investment. If you are an owner of a vacation property, you should check with your tax advisor to see if you qualify for tax deferment. Second homes do not qualify.

If you are a "dealer" in property you are not eligible to take advantage of the 1031 provision. You may lose your 1031 opportunity if the IRS determines that the land is inventory.

Your tax advisor will be able to determine which category you fall under.

 The Reverse Exchange

The IRS has finally approved Reverse Exchanges. In Revenue Procedure 2000-37, which was effective 9/15/2000, the IRS provided guidelines on how to structure a Reverse Exchange.

Now, Revenue Procedure 2000-37 sets out Safe Harbor Rules for a Reverse Exchange. The new rules apply to a Reverse Exchange where title to the Replacement Property is held by the Intermediary ("Parked" with the Intermediary) until the Relinquished Property Sale closes. The new rules also apply to a Reverse Exchange where title to the Relinquished Property is held by the Intermediary ("Parked" with the Intermediary) until a Real Buyer closes the purchase of the Relinquished Property.

If you are interested in participating in a 1031 Tax Deferred Exchange, please contact one of our experienced agents to discuss your options, and connect you with one of the "Qualified Intermediaries" we associate with.

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