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1031 Tax Deferred Property Exchanges

"The greatest thing a man can do in this world is to make the most possible out of the stuff that has been given him. This is success, and there is no other." Orison Swett Marden

Home Investor Selling Rule #3

"Leverage your profits by deferring capital gains taxes whenever possible using a 1031 Exchange to allow 100% of gains to be reinvested."

The current (as of 2004) US tax code allows investors to move capital in a property investment portfolio while deferring capital gains taxes, allowing you to reinvest 100% of your investment gains in new projects. The methodology for doing this is commonly referred to as a “1031 Exchange”, named after Section 1031 of the tax code.

Introducing 1031 Exchanges

As an introductory matter, you should know three things about Section 1031 exchanges:

1. You can exchange your property for new property without now paying federal or state gains tax on that exchange if the requirements of Section 1031 are met. (Applies to most states).

2. The exact structuring of the exchange will depend on, and can be tailored to, your circumstances.

3. You should obtain sound legal and tax advice before undertaking a Section 1031 exchange.

A 1031 Exchange allows you to sell a property such as a rental home for a profit and take that profit and reinvest it without paying capital gains taxes at the time of the sale. (The taxes are deferred to a later date). This is similar in concept to a 401K but for Property; you only pay the taxes when you take the money out of the investment. Just as you can reinvest from one fund to another in a 401K without tax penalties, it is possible to reinvest gains from a property investment under a 1031 Exchange.

Engaging in a like-kind exchange permits the property owner to reinvest 100% of the proceeds that would result from a straightforward sale of existing property (the "relinquished property") in the new property that is acquired in the exchange (the "replacement property").  In contrast, an actual sale of the relinquished property followed by the payment of tax would leave only 80% or less of the gain available for reinvestment.

Taking advantage of this opportunity requires careful planning in order to comply with the strict rules for a 1031 Exchange.

What types of property may be included in a Section 1031 Exchange?

•  Exchanges may involve real property or tangible personal property; it excludes stocks, bonds, partnership interests and similar “intangible property”.

•   The properties must be used in a business or held for investment, and must be similar in nature (real property is given up for real property or equipment is exchanged for similar equipment.

•  Section 1031 permits flexibility; for example, unimproved land (real property) may be exchanged for an apartment building (real property).

Real property is the most commonly used asset for Section 1031 exchanges.  Real estate is a good candidate for exchanges since it generally appreciates in value over time, resulting in significant gains and therefore a material tax liability, which can be deferred in an exchange.

There are two basic requirements for real property to qualify for a Section 1031 exchange: (i) the property must be ‘used in a trade or business or held for investment’; and (ii) it must qualify as real property under applicable state law.

The IRS code provides significant flexibility for owners of real property to complete Section 1031 exchanges. It is possible to exchange real property via a delayed or forward exchange, a reverse exchange or a construction / build-to-suit exchange (see over). Also, any real property that is used in a trade or business or held for investment can be exchanged for other business or investment real property. This means that land can be exchanged for residential property, residential can be exchanged for commercial, or commercial property can be exchanged for industrial property and still meet the Like-Kind Requirement.

It is possible to exchange different quantities of properties; for example a property owner can sell two properties and take back one, or sell one and take back three to complete a Section 1031 exchange. It is also possible to exchange a property that is involved in a foreclosure.  An exchange in this circumstance will help the property owner to lessen the negative financial impact of the foreclosure.

A property owner, however, cannot enter into a like-kind exchange for a personal residence, whether it is a primary residence or a second home that does not qualify as an investment property.  There is a personal residence exclusion of $500,000 ($250,000 for single taxpayers) available to homeowners for their primary personal residence.

To qualify for tax deferred treatment, it is important that the owner have no access to the proceeds realized on the sale of the existing property to avoid constructive receipt – the owner may only receive the replacement property in the exchange. The use of a qualified intermediary can resolve the constructive receipt issues so the exchange can qualify as tax-free. (An example of such a qualified intermediary is Atlantic Exchange Company, LLC in Boston, www.aec1031.com). As a result, the industry practice and custom is to use a qualified intermediary to facilitate the exchange.

A properly structured Tenancy in Common ('TIC') interest in a qualifying 'business or investment' property is acceptable for a Section 1031 exchange.  A TIC interest is a form of joint ownership whereby multiple investors each acquire an undivided fractional interest in a property.  Acquiring a TIC interest as replacement property can be an effective strategy combined with a Section 1031 exchange.  For example, owners of actively-managed properties such as multi-unit residential properties can exchange into an ownership position in a Triple Net Lease Property (NNN Property: characterized by (i) a lease of a facility to a single tenant, usually a large publicly traded corporation; (ii) The lease usually has a long primary term ranging from 10 to 25 years; (iii) Pursuant to the lease, the tenant makes a periodic payment of a fixed amount to the owner of the property, which is not subject to any reductions; (iv) The tenant assumes all responsibility for taxes, insurance and maintenance and repair related to the property) or a professional managed building that generally requires little day-to-day active involvement.

Alternative Exchanges

The exact structure of your exchange will depend on your particular circumstances.

(i) It may be that you cannot now locate the replacement property and you will not be able to complete a Simultaneous Exchange.  Therefore, you may need to complete a 'Delayed' or 'Forward' Exchange which allows you to transfer your relinquished property today and purchase your replacement property later.  However, the applicable rules require you to meet certain time-lines in completing your acquisition of the replacement property.

(ii) In other circumstances, you may have located the replacement property but have not yet found a buyer for your property.  Here, a Reverse Exchange is in order.

(iii) Finally, you may want to receive replacement property that needs to be constructed or improved before it is received by you, and that too can be done through a Construction or Build-to-Suit Exchange.

For more information on Section 1031 Exchanges, contact your local Home Investor Specialist or refer to www.AEC1031.com for comprehensive information from the Atlantic Exchange Company.

Our thanks go to the Atlantic Exchange Company (tel 877-AEC-1031) for supplying the content for this section.