Section 1031 Exchange: What is it?

“Under Section 1031 of the United States Internal Revenue Code , the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due.” (Source: en.wikipedia.org/wiki/1031_exchange)

What a Section 1031 exchange is not:

-A way to exchange like-kind “tax-free”

-A method of exchanging a personal residence or vacation home

-A legitimate means of getting cash or other proceeds prior to completing the exchange

-A way to exchange real property within the United States with real estate outside of the United States.

-A process of exchanging real property like-kind to personal property.

The Section 1031 has become ever increasingly more popular since the mid-1990’s as a means for investors to sell businesses or investment properties without realizing capital gains tax at the time of the sale by reinvesting the proceeds into a similar property that qualifies as a “like kind” exchange.

The theory behind the Section 1031, according to the Federation of Exchange Accomodators, ”when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain.”

There are several different 1031 structures to consider of which a few are described here:

  • Simultaneous swap-.The simplest of the exchanges; as the name implies the relinquished property is exchanged simultaneously for the replacement property.

  • Deferred exchange- Although more complex, this is the most common type of exchange with allows for time to lapse between the sale of the relinquished and the purchase of the replacement. This type of exchange is subject to very strict timeframes with which the replacement property must be identified within 45 days of the relinquished properties sale date. Additionally the replacement property must be received and exchanged within 180 days of the sale of the exchanged property or the due date of the taxpayer's federal tax return for the year in which the relinquished property was transferred, whichever is earlier.

  • Reverse exchange- The most complex of the exchanges and is typically performed in conjunction with an exchange accommodation titleholder. This service provider assists with the acquisition of the replacement property and provides a “parking arrangement” for the asset prior to the relinquished property being transferred. Once again strict timelines are in effect with this type of exchange as well.

What happens if you miss the strict timelines of the exchanges?

The exchange will fail and the investor owes any taxes that are a result of the sale of the relinquished property…no exceptions allowed.

When are the taxes paid?

Ultimately, when the replacement property is sold then the investor is liable for the original deferred gain in addition to any realized gain since the purchase of the replacement property.

It is important to realize that there are many stipulations to performing a successful 1031 exchange and the penalties for not meeting all the requirements for a valid exchange can be unforeseen and costly for an inexperienced investor.

Always consult a Qualified Intermediary, legal advisor, or tax consultant with questions about whether you qualify, will benefit, or how to structure a 1031 exchange to best meet your business needs.

http://www.1031.org/about1031/faq.htm

http://www.1031.org/pdf/IRSFactSheet.pdf

 

1031 Exchanges: The Basics

Internal Revenue Code Section 1031, (Wikipedia).

1031 Exchange Manual, (1031 Corporation).

A Primer on 1031 Exchanges, (Small Business Review, 2010).

The 1031 Exchange in Today's Market, (Realty Times, June 18, 2009).

1031 Exchange FAQs, (Federation of Exchange Accomodators).Compound logic: The Wealth-Building Power of 1031 Exchanges Just Makes Sense, (Commercial Investment Real Estate, Sept.-Oct. 2008).