The Basics of IRC Section 1031 Deferred Exchanges

With the potential for substantial cash savings in every transaction, tax-deferred real estate exchanges are becoming a preferred choice for commercial and residential real estate. Federal law today encourages tax deferred simultaneous and delayed exchanges of qualifying property. Although you may have been led to believe that exchanges are somehow complicated and thereby mysterious, they are actually fairly easy and straightforward provided you follow certain guidelines established by the Internal Revenue Service. I am going to take this from the beginning so that when we are finished you should have a fairly concise roadmap on how to proceed with an exchange.

First, let's define a tax-deferred exchange. A tax-deferred exchange is simply a method by which a property owner trades one property for another without having to pay any federal income taxes on the transaction. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property. But in an exchange, the tax on the transaction is deferred until some time in the future.

Tax deferred exchanges are authorized by Section 1031 of the Internal Revenue Code. IRC 1031 provides that the exchange of certain types of property will not result in the recognition of gain or loss: "No gain or loss shall be recognized if property held for productive use in a trade or business or for investment purposes is exchanged solely for property of like-kind". The requirements of Section 1031 must be carefully met, so that when an exchange is done properly, the tax on the transaction will be deferred. The transaction must be structure in such a way that it is in fact an exchange of one property for another, rather than the sale of one property and the purchase of another.

Typically, there are four parties to a properly structured exchange. First, there is the taxpayer, sometimes called the Exchangor. The taxpayer is the person who has the property and would like to exchange it for new property. Second, there is the Seller, the person who owns the property that the Taxpayer would like to acquire in the exchange. Third there is the Buyer, the person who has cash and would like to acquire the taxpayer's property. Finally, there is the "Intermediary" who plays a vital role in almost all exchanges by buying and then reselling the property in return for a fee.

The properties involved in the exchange also have special names: The Relinquished Property is the property originally owned by the Taxpayer and in which the taxpayer would like to dispose of in the exchange. On the other hand, there is the Replacement property, which is the property that the taxpayer would like to acquire in the exchange.

In order for a transaction to qualify for a tax-deferred treatment under Section 1031, certain requirements must be met:

• Generally, tax deferred exchanges are limited to real property.
• Exchange properties must be investment or income properties.
• Replacement property must be "like-kind" (all real property is "like-kind". Real property is not like-kind to personal property)
• Generally, property must be held for one year to qualify for tax deferred treatment.
• Taxpayer must avoid constructive receipt of any sale proceeds, earnest money deposits or any other transaction related funds. The Intermediary should escrow these funds.
• All time limits must be met for deferred exchanges. Identify the replacement property within 45 days of closing the relinquished property. Close on the replacement property within 180 days of closing of relinquished property.
• For a fully tax deferred exchange, the taxpayer must trade even or up in value and equity.

The purpose of this article is to bring to attention the opportunities available in engaging in a tax-deferred exchange as an investment strategy. A 1031 tax-deferred exchange is not difficult, but there are very strict rules and timetables that must be followed. If you follow these established guidelines in effecting an exchange you should have "NO PAIN AND NO GAIN".