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What is a 1031 Exchange?
Section
1.1031, of the Internal Revenue Code of 1986, as amended, offers real estate
investors one of the last great investment opportunities to build wealth and
save taxes. By completing an exchange, the investor (Exchanger) can dispose of
their investment property, use all of the equity to acquire replacement
investment property, defer the capital gain tax that would ordinarily be paid,
and leverage all of their equity into the replacement property. Two
requirements must be met to defer the capital gain tax: (a) the Exchanger must
acquire like-kind replacement property and (b) the Exchanger cannot receive
cash or other benefits (unless the Exchanger pays capital gain taxes on this
money). The tax code states: "No gain or loss shall be recognized on the
exchange of property held for productive use in a trade or business or for
investment purposes if such property is exchanged solely for property of a
like-kind which is to be held for either productive use in trade or business or
for investment purposes." Investors can accomplish virtually any investment
objective with exchanges including greater leverage, diversification, freedom
from joint ownership, improved cash flow, geographic relocation and/or property
consolidation.
What is involved in a delayed
exchange?
A typical tax deferred exchange is very similar to a taxable
transaction except that prior to closing on the property being sold,, a
qualified intermediary, is assigned into the Sale Contract. They sell the
property to the buyer and transfer the proceeds safely into a separate exchange
account. (The IRS stipulates the exchanger cannot be in actual or constructive
receipt of funds at any time during the exchange.) The exchange period begins
with the transfer of the first property providing the investor 45 days to
identify, and a total of 180 days to close, on "like-kind" replacement
property. The exchange is completed when the qualified intermediary is assigned
into the Purchase Contract, utilizes the proceeds received to acquire the
replacement property, and instructs the closer to transfer ownership to the
exchanger via direct deeding.
What are the exchange requirements?
- Purchase Equal or Greater Value
- Reinvest all Net Equity
- Equal or greater debt. (Exception: A reduction in debt
can be offset with additional cash, however a reduction in equity cannot be
offset by increasing debt.)
Exchanges must be completed within strict time
limits with absolutely no extensions. The Exchanger has 45 days from the date
the relinquished property closes to identify potential replacement properties.
This involves a written notification to the Qualified Intermediary listing the
addresses or legal descriptions of the potential replacement properties. The
purchase of the replacement property must be completed within 180 days after of
the close of the relinquished property. After the 45 days has passed, the
Exchanger may not change their Property Identification list and must purchase
one of the listed replacement properties or the exchange fails!
To avoid the payment of capital gain taxes the
Exchanger should follow three general rules: (a) purchase a replacement
property that is the same or greater value as the relinquished property, (b)
reinvest all of the exchange equity into the replacement property, and (c)
obtain the same or greater debt on the replacement property as on the
relinquished property. The Exchanger can offset the amount of debt obtained on
the replacement property by putting the equivalent amount of additional cash
into the exchange.
In the case of real property exchanges, the
Exchanger must sell property that is held for income or investment purposes and
acquire replacement property that will be held for income or investment
purposes. This is the like-kind property test. I.R.C Section 1031 does not
apply to exchanges of stock in trade, inventory, property held for sale,
stocks, bonds, notes, securities, evidences of indebtedness, certificates of
trust or beneficial interests or interests in a partnership.
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