The 1031 Exchange is a valuable tool that real estate investors can use to defer capital gains taxes. It takes its name from the section of the IRS Code where it is defined, Section 1031. The basic concept is that of "like-kind" exchange of investment or business property. At its heart, a 1031 Exchange is a trade, but it can be a very complicated trade. You can't just sell one property and then go out and buy another. There are extremely specific rules and qualifications.

Qualifications

First, to qualify, the acquisition and relinquishment of the properties must be "mutually dependent parts of an integrated transaction constituting an exchange of property." The capital gains taxes owed on a real estate investment property sale may be deferred using 1031, as long as a similar "like-kind" property is purchased using profits earned from the first property's sale. The properties must be business or investment properties. To defer capital gains taxes completely, the replacement property must be of equal or greater value. There is a 45 day identification period and a total 180 day completion period for the exchange. Here are the major types of 1031 Exchanges:

• Simultaneous Exchange: To qualify as a simultaneous exchange, both properties involved must close on the same day. This is either done as a straight swap between the two parties, with the help of a third accommodating party, or through a qualified intermediary. For various reasons, the accommodating party route is not recommended. As you can no doubt see, this simultaneous exchange can be a difficult feat to pull off, and failure, or even excessive time between the logistics, can disqualify the exchange, with full taxes being due. For this reason, most of the 1031 Exchanges now done are not done as simultaneous exchanges.
• Delayed Exchange: This is the most typical type of 1031 Exchange. The property to be relinquished is transferred first. An intermediary receives the proceeds. Then there is a 45 day period permitted to designate the replacement property. The exchange Intermediary initiates the actual transaction. The new, or replacement, property must be closed on within 180 days of the first property's closing. An Improvement or Construction delayed exchange may allow you to improve the replacement property during this time frame, but the 180 day deadline and other requirements could be challenging.
• Reverse Exchange: You can buy the desired property first, through an exchange accommodation titleholder. But that means coming up with the purchase price prior to the sale of your property. And there are a number of other rules that must be followed exactly. Strict time limits include 45 days to identify the relinquished property. After that, you are given up to 135 days to close on the exchanged properties. If the deadlines are not met, the favorable deferred capital gain tax status is lost.

Other Aspects of the 1031 Exchange

The 1031 Exchange rules used to apply to a broader range of assets, but now only apply to real estate. "Like-Kind" does not mean the properties must be exactly alike. Land can be swapped for buildings, for example, or even one type of business for another. To defer 100% of the taxes, the net market values of the properties must either be the same or that of the property purchased must be greater. If the value is lesser, a portion would not be tax free. Any cash left over is termed "boot" and is taxable.

One attractive aspect of these exchanges is that the exchanged purchased property does not have to be one property. It could be numerous properties, as long as they are "like-kind" investment properties. A 1031 Exchange can be done as many times and as frequently as an investor would like, even possibly for a vacation home. But there can be pitfalls to 1031 Exchanges, such as depreciation recapture on depreciable properties when traded for land, for example. Contact Chandler & Knowles CPAs, your tax and accounting experts, for further clarification and advice.