IRS §1031 Tax Exchange Overview

In 1990 the Internal Revenue Service issued the rules on Deferred Exchanges. Section 1.1031 of the Internal Revenue Code details the procedure for turning a sale and purchase type transaction into an exchange.

The §1031 exchange provides investors with one of the better tax strategies for maintaining the value of their portfolio. This process permits the investor to defer the capital gain taxes that would normally be incurred on the sale of an investment property.
The rules permit “like-kind” exchanges of business and investment property. In short, you may sell and purchase a “like-kind” property with the proceeds from your sale without paying capital gain taxes. By using the exchange process one can purchase a more expensive property since all of the equity from the sale are applied to the replacement property. The term “like-kind” for Real Property is quite broad, and it includes land, rental and business property ….. each type may be exchanged for the other, or a combination of each.

There are 4 classifications of Real Estate recognized by the IRS:

Note: The last two qualify for Section §1031 tax deferral, the first two do not. The property received and the property sold must be of like-kind. Your use of the property determines its classification.

To meet the requirements of the §1031 exchange, the “exchanger” is required to use a “Safe Harbor” to hold the proceeds while the exchange is in progress. The only practical Safe Harbor for most exchangers is a qualified intermediary.

The exchanger has a period of forty-five (45) days following the closing of the exchange sale to identify the replacement property, or properties. The equity from the exchange sale will be wired to a trust account and held by the “Safe Harbor”. This is essentially the beginning of the forty-five (45) day identification period. It is also acceptable to use the equity from your exchange to purchase more than one property. You may exchange land for a duplex, or a commercial building for a retail store. Within this forty-five day identification period, the exchanger will identify the replacement property, or properties, and obtain a fully executed purchase agreement for the replacement property. You now have one hundred and eighty (180) days to close on all of the properties you identified as being a part of the exchange. If you are working with a realtor, the realtor will identify the exchangers intensions to use the §1031 Tax Exchange on their listing agreement, and again in the multiple listings system (MLS). This statement will also be a noted on the purchase agreement for the replacement property, or properties. You or your agent must notify the closing agent when a §1031 Tax Exchange is being used so they may properly communicate with the qualified intermediary.

If there are any equity funds remaining, it will be returned to the exchanger. These funds are referred to as “boot”, and will be taxed on their full amount.

It goes without saying that there is much more to the §1031 exchange process than outlined in this brief overview. Should you have an interest in pursuing a §1031 tax exchange, it is in your best interest to contact and consult with a qualified intermediary before going forward with the process.