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What is a 1031 Tax Deferred Exchange?
Simply stated, a 1031 Exchange is a rollover of equity of like properties. Under section 1031 of the Internal Revenue Code, a taxpayer may completely defer payment of taxes by trading, rather than selling his or her real estate. A 1031 exchange is an opportunity for the seller and buyer of investment property, or property used in a trade or business, to save in taxes and leverage income growth.
Selling a business or investment property typically requires payment of capital gains taxes. The tax bill can be heavy depending on the property's appreciation in value and length of time depreciated. However, under the 1031 Exchange, capital gains can be deferred or avoided if you "exchange" the property through a "Qualified Intermediary", i.e. a Title Company or a Realty Exchange Company.
How to go about a 1031 Exchange:
Taxpayer finds a buyer and sells the property through a Qualified Intermediary.
Taxpayer finds another property that fits their needs.
Taxpayer buys replacement property through the Intermediary. The parties may not know each other and their properties can be in different states.
You can buy replacement property or properties of any kind with your proceeds from the sale as long as the fair market value totals less than 200% of the fair market value of the relinquished property or properties.
The properties do not have to close at the same time. The taxpayer has 45 days after the settlement to find replacement property(s) and 180 days (or before taxes are due that year) to settle on the new property(s).
The Intermediary should be financially strong with knowledge to make the transaction hassle and worry-free. You may want to search for a Realty Exchange Corporation. The taxpayer's agent, broker, attorney, accountant, or family member is excluded as an intermediary.
What is the benefit of not paying taxes now?
The wealth of using equity you save by not paying the taxes now can be used to buy more investment property. And, when your heirs inherit your investment property, they take it over at its current market value. Any tax liability will be limited to the gains from the date of their acquisition, not during the years of your ownership. So, in essence the taxes you are saving now are never paid.
Frequently Asked Questions about 1031 Tax Deferred Exchanges
Q. Is the 1031 exchange a tested concept ?
A. The 1031 Exchange has more recently become popular as a result of IRS "Safe Harbor" regulations in 1991. However, astute real estate investors have been utilizing the exchange concept since the mid 1920's.
Q. How does the real estate investor benefit in a 1031 Exchange ?
A. In effect the taxpayer receives an interest free loan from the Government in an amount equal to the capital gains tax that would have been paid. Deferral of capital gains tax affords greater investment capital for acquisition of a replacement property. One of the major advantages of real estate as an investment is the investors ability to leverage. Going shopping with that larger block of (preserved) equity allows the investor to acquire a much higher valued replacement property.
Q. How does one research their advantages in an exchange transaction ?
A. While there remains (in some circles) a cloud of skepticism lingering over the 1031 Exchange concept, in reality current IRS "safe harbor" Regulations make the exchange a safe, practical tax planning alternative. The initial step in planning an exchange should be to arrange for an "Exchange Feasibility Review".
Q. How does one obtain an "Exchange Feasibility Review" ?
A. The ideal consultant for an "Exchange Feasibility Review" is a CCIM who specializes in 1031 Exchanges and has a thorough knowledge of the investment real estate market. It is important to point out that any final structuring of an exchange should be reviewed for approval by the investors tax counsel.
Q. What's involved in an "Exchange Feasibility Review" ?
A. An "Exchange Feasibility Review" will determine up front whether an exchange is in the best interest of the investor and establish the groundwork for a successful exchange transaction. It's a preliminary structuring of the exchange transaction outlining the steps to be taken and the all important timing of those steps. A primary goal is to establish the investor's motivation for moving out of the "Relinquished" property. Perhaps refinancing and restructuring to acquire a second property would provide a better overall after tax return and potential for wealth accumulation.A review would include
1. A scrutiny of qualified property (like kind).
2. Develop an investment profile of
alternative "Replacement" property.
3. Balancing of equities.
4. Calculation of realized and recognized gain.
5. Calculation of carry over basis in replacement property
Q. What is a "FACILITATOR" ?
A. A "FACILITATOR" is a qualified intermediary that interacts between the parties in an exchange transaction. A qualified intermediary is defined as a person, or entity, other than the taxpayer (or person related to the taxpayer) who for a fee, acts to facilitate an exchange by;acquiring the relinquished property from the taxpayer and acquiring the replacement property and subsequently transferring it to the taxpayer/exchangor.
Q. Where can one find a "FACILITATOR" ?
A. Your CCIM, CPA, or Tax Attorney might provide a list of facilitator companies. It might be a good idea to select a facilitator that is a tax practitioner, a tax attorney or CPA with an in-depth knowledge of IRS Regulations regarding 1031 Exchange transactions.
Q. What are the major concerns in structuring a 1031 Exchange ?
A. 1. "Relinquished" as well as "Replacement" properties must qualify as Like Kind. . . be held for investment or productive use in trade or business.
2. Trade up or even in value.
3. Trade up or even in equity.
4. The taxpayers motivation must be to exchange.
5. The taxpayer can not have access to or have constructively received transaction funds.
6. The transaction must be structured as an exchange.
7. Identification and closing time requirements must be strictly adhered to.
Q. What is like Kind ?
A. Like kind refers to the nature or character of a property, not to its grade or quality. Generally, any property held for investment or use in trade or business will qualify as like kind. Raw land can be exchanged for an apartment building, an office building for a strip center, an industrial building for a hotel, etc. It should be pointed out that our law makers are considering tighter restrictions of the rules on "like kind".
Q. Can an exchange be partially taxed ?
A. Yes, if all of the equity from the relinquished property is not used to acquire the replacement property the unused portion is considered 'BOOT" (unlike property) and is subject to tax.
Q. What is "BOOT" ?
A. "BOOT" is defined as unlike property received by the taxpayer in an exchange transaction; cash, paper, debt relief. etc.
Q. When is it too late to structure an exchange ?
A. An exchange can be structured any time prior to the closing of the relinquished property. However, it is in the interest of the taxpayer to contract for the services of a facilitator upon completion of the "Exchange Feasibility Review".
Q. Can I exchange my apartment building in the city for a vacation home at the beach?
A. NO if it is to be your vacation home. YES if the beach property is to be rented out and held for investment.
Q. Can I live in one unit of a multi-unit building I acquire as a replacement property ?
A. Yes, however pro-rating values between personal and investment portions must be addressed.
Q. Can I exchange a number of properties for one property ?
A. YES, you can also exchange one property for a number of properties as long as they are qualifying properties.
Q. Can I exchange an apartment building valued at $400,000, acquire vacant land for $100,000 and use the remaining $300,000 to build a new apartment building on the vacant land?
A. Yes, but,
1. The remaining $300,000 cash must stay in the exchange.
2. The new construction must be completed in the 180 day window otherwise the uncompleted portion may not qualify.
Q. Must I pay the deferred capital gain tax eventually ?
A. Not necessarily. Prudent tax planning in your real estate portfolio can provide a shelter against the eventual payment of deferred capital gains tax.
Q. Is an exchange always beneficial to the real estate investor ?
A. Not always. The purpose in an exchange is for nonrecognition of gain or loss in the disposition of a real estate holding. It might be to the investors advantage to recognize a gain, and certainly to recognize a loss. If the investors motivation is to acquire another investment property, it may be to the investors advantage to refinance property "A" and acquire Property "B" with the refinance funds. "Alternative Strategies" should be examined through an "Exchange Feasibility Review"
Q. What is a delayed exchange ?
A. When there is a time span between closings on the relinquished property and acquisition of the replacement property.
Q. What are the time constraints in a delayed exchange ?
A. The clock begins ticking with the closing (settlement) on the relinquished property. The taxpayer has 45 days from that closing date to identify replacement property and 180 from that same closing date to close (settle) on the replacement property.
Q. What happens if either the 45 day or 180 day stipulation are not met ?
A. Upon the expiration of the 45 day or 180 day stipulation the transaction then becomes a sale and a taxable event. (There are no extensions)
Q. If I enter into a 1031 Exchange can I withdraw mid stream ?
A. Yes, and pay any taxes due on your capital gain at closing.
Q. Can I add cash in the exchange and acquire a more expensive property ?
Q. Can I acquire a replacement property prior to closing on my relinquished property?
A. Yes! This is considered a reverse delayed (Starker) exchange. However, current "safe harbor" regulations do not address reverse exchanges, therefore they may be subject to greater scrutiny and risk of audit. Again, a qualified facilitator can chart the course around the hazards.
Q. Can I add an investor in the property being acquired?
A. Yes, but be aware of the tax impact "Investor, not partner"
Q. How long must I hold the replacement property ?
A. There is no absolute rule. Intent and motivation very much come into play. However, special rules apply to related parties where the acquired property must be held for 2 years.
Q. Can a partnership exchange qualify for a nontaxable event?
A. The partnership must exchange as the partnership entity in order to qualify for a nontaxable event.
Q. Can partners in a partnership exchange their interest in a property and go their separate ways?
A. The partnership can be dissolved (if practical) and have the individual partners interests in the property deeded out as tenants-in-common. The partners can then sell or exchange their interests separately.
If you hold title to your 1031 property with one or more persons as co-tenant owners, each of you having an individual interest, but you have filed a partnership return, then you must determine whether the partnership or the individual title owners should enter into the exchange agreement. Before proceeding with the exchange, this matter should be resolved with tax counsel.
"I was involved in a good many 1031 Exchanges when I was practicing real
estate and also had a number of my tax clients involved in exchanges.
is a primer I wrote a number of years ago. It needs a little work but
fundamentals are there. Feel free to use it."
Methods of Exchanging Real Property
In order to properly understand the procedures and methods of tax
exchanging, it is important to understand the basic structure of the
and in some cases, the history behind its development. Tax law is
evolutionary in nature. It can be broken down into 4 basic areas.
1. Internal Revenue Code as amended
2. Treasury Regulations, constantly changing to keep up with the
3. Rulings, developed around specific situations
4. Case Law, the courts interpretation of the Code, Regulations, and
It is easy to see why the tax law is evolutionary. As congress
amend the Code to accomplish social and economic agendas, the entire
tax law grows.
The current Code leaves us with few tax shelter vehicles. The primary
1. Interest deductions on up to two personal residences
2. Retirement accounts
3. Schedule C for self employed individuals with proper record keeping
4. Investment real estate
Keep in mind that rules differ from personal use real estate to
real estate as we discuss some of the basic concepts
necessary for the understanding of exchanging.
Types of income
1. Active - salaries, wages, business profits
2. Portfolio - interest, dividends, royalties
3. Passive - limited partnerships, rental real estate
Passive loss limitations
If you earn under $100,000 modified adjusted gross income and you
"actively participate" in the management of the property, you can
to $25,000 in losses, the balance are "suspended", to be used the
years or upon disposition of the property. The deduction is phased out
between $100,000 and $150,000, $1,000 in deduction for every $2,000 of
This is an important concept. You can't calculate the capital gain
you know the basis.
Original Cost + Capital Improvements - Allowable Depreciation
Gift - donors basis or fair market value, which ever is less
Inheritance - fair market basis at death
Property received in exchange - fair market value less deferred gain
Difference between the adjusted selling price and the adjusted basis.
Capital gain is divided into three categories.
Realized Gain - actual gain, reported in year of sale
Recognized Gain - taxable gain, taxed now
Deferred Gain - tax is deferred, taxed later reduces basis of property
received in exchange
Theoretical drop in the value of an asset for tax purposes only. A
expenditure. Treated as a deduction but reduces basis, which will
a larger capital gain. This taxed depreciation is said to be
The period over which the property is depreciated is called the
period and has changed many times over the years.
Residential income property - 27.5 years
All other income property - 31.5 years
Optional recovery period - 40 years
Under the Tax Reform Act of 1986, real property depreciation is
line taken over the life of the asset.
Under the Economic Recovery Tax Act of 1981 (1981), depreciation could
accelerated to the early years. This was known as "accelerated cost
system" or ACRS.
Each new owner establishes a new depreciable basis based on cost of
acquisition minus any deferred gain. Land is considered indestructible
is not depreciable. The value of the land must be determined and
from the basis of the property to arrive at the depreciable basis.
Why exchange real property? To save taxes, yes, but said more
build your estate with pre-tax dollars. Using proper exchange
results effectively in interest free loans from the government. Other
reasons to exchange include:
Increasing depreciable basis by acquiring property encumbered with a
Acquiring sheltered income by exchanging for unimproved land for
Acquiring property without cash, when sales may be impossible.
Consolidating assets by exchanging many properties for one larger
Receiving nontaxable cash by exchanging and refinancing after and
independent of the exchange.
Leveraged 4 to 1 results in a purchase of $280,000
10% annual appreciation results in $28,000
If you structured the sale in accordance with section 1031, and did not
to pay the taxes at that time, you could invest the entire
$100,000 leveraged 4 to 1 and purchase a $400,000 property. At 10%
appreciation, your increase in equity is $40,000. Multiply this $12,000
equity buildup over a 20 year investment horizon and the result is
Internal Revenue Code Section 1031
No gain or loss shall be recognized if property held for investment is
exchanged solely for a property of like kind to be held either for :
1. Production of income
3. Productive use in trade or business
Property must be of "like kind." This means real property for real
personal property for personal property. "Like kind" is broadly
that is, all real estate qualifies regardless of the "grade or
is the "nature or character" of the property (realty or personalty) and
the name of the improvements (office building, apartment, hotel, etc)
determines "like kind". This was emphasized in Commissioner of
Revenue v. Chrichton. This case involved the exchange of mineral
and improved real property. The mineral interests were held to be like
property because under state law they were considered real property. In
subsequent revenue ruling, the IRS indicated that water rights also met
like kind test.
Nothing in Section 1031 prevents a taxpayer from exchanging out of or
Exchanges can be fully deferred or partially deferred. Any unlike kind
property received in the exchange is considered boot and is recognized
(taxable) in the year of the exchange. Boot is:
1. Cash or the equivalent of cash
2. Any unlike kind property
3. Mortgage relief
4. Any combination of the above
Cash paid offsets mortgage relief boot. The lower of the gain or the
taxable in the year of the exchange.
For a completely tax deferred exchange you must trade up in equity,
Basis of Property Received
This is referred to as substitute basis and is the Fair Market Value of
property received minus the deferred gain (or plus any deferred loss).
As it is in any real estate transaction, you must first identify the
objectives of the property owner. What do they want to accomplish?
Management problems, lack of control, cash flow, tax concerns;
owner is not sure of all the circumstances and it may take some time
counseling to make the determination.
A basic requirement is that all participants receive the same value
that they give. The end result should be that there are as many winners
there are participants. Determination of value to the participants in a
estate exchange is not complete without considering the improvement the
transaction will make in the owner's life. The analysis must take into
consideration the personal circumstances of the participants lives.
Two Party Exchange
As mentioned before, to structure a completely tax deferred exchange,
investor must acquire property (properties) with equal or greater
a larger fair market value than the property transferred (up in equity
value). This assumes that there is gain realized and that the taxpayer
pays boot and assumes a larger loan.
Mr. Smith owns an industrial property valued at $372,000 with a loan of
$351,000. His basis is $355,000.
He exchanges with Ms. Jones apartment complex which is valued at
$420,000 and has a $381,000 loan against the property. His basis is
Step 1: Balance the Equities
Basic Structures of a Multiparty Exchange
The very common three party exchange is comprised of a sale and an exchange, or an exchange and a sale.
The information contained here are in no manner intended to be interpreted as tax or legal advice or counsel.
Please seek legal and tax advise
from qualified professionals.
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