What is a 1031 Exchange?

Tax-Deferred Exchange

A 1031 tax-deferred exchange enables investors to reinvest the proceeds from the sale ofinvestment property in one or more replacement properties without incurring immediate federal(and most state) capital gains taxes on the appreciated value. When the sale and purchasemeet the 1031 exchange criteria, taxes are deferred until the newly acquired property is sold.This deferral strategy can be repeated through any number of exchanges until the tax liabilitypasses into the individual's estate upon death.

Section 1031 Requirements

Replacement property acquired in a 1031 tax deferred exchange must be "like-kind" to theproperty being sold. Like-kind means "similar in nature or character, notwithstandingdifferences in grade or quality." In order for the properties to qualify as "like-kind" they mustbe held for productive use in a trade or business or held for investment purposes.A 1031 exchange may involve any of the following property types:

Single Family Rentals
Multi-Family Rentals
Office Buildings
Storage Facilities
Raw Land
Retail Shopping Centers
Industrial Facilities

The general guidelines to follow in order for a taxpayer to defer all the taxable gain are as follows:

The value of the replacement property must be equal to or greater than the value of the relinquished property.
The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.

There are strict timeline and identification rules that must be followed for a 1031 exchange.First, the investor must identify replacement property within 45 calendar days of the close onthe relinquished property. This identification must be in writing, and can follow one of threepossible identification rules:

3-property rule: Up to three properties are identified no matter what their value.
200 percent rule: Any number of properties is identified as long as their combined fair market value (FMV) does not exceed 200% of the FMV of the relinquished properties.
95 percent rule: Any number of properties are identified no matter what the aggregate FMV, provided 95% of the value of the identified properties is acquired.

Second, the investor must close on the identified replacement properties within 180 days from theclose date of the relinquished property.

Moreover, an independent third party must serve as aQualified Intermediary (QI). The QI is required to hold the proceeds of the sale of the relinquishedproperty until the proceeds are reinvested. There must also be a written "exchange agreement" betweenthe investor and the QI which serves to protect the investor from having "constructive receipt" of theexchange funds during the exchange period. The QI's role is to ensure these rules are properlyfollowed and that the equity is preserved. IRC rules require the investor to have a QI to complete a1031 exchange.

A 1031 exchange can be an effective tool for building wealth. However, investors must work withtheir professional tax advisor to meet the requirements of IRC Section 1031, as failure to complywith IRC Section 1031 or an unfavorable tax ruling may cancel deferral of capital gains and resultin immediate tax liabilities, including tax penalties.