The Tax Deferred Exchange

Section 1031 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 if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or the investment.” 

Not “recognizing” a gain is what creates the tax advantage and the taxes are deferred until the gain is recognized later. It is also important to understand that the term “like-kind” refers to the nature or character of property and not to its grade or quality. Therefore, no distinction is made between the types of real estate that can be exchanged. For example, improved real estate for unimproved real estate, city property for farms or ranches, and commercial property for developed or undeveloped land. 

If your objective is to continue to invest in real estate, the Section 1031 Tax Deferred Exchange is for you. It allows you to invest more funds into the next property because no taxes will be paid currently under the exchange. Other benefits would be to transfer your investment from non-income (raw land) to income property (cash flow). You could also consolidate multiple properties into one property or convert a large property into many smaller properties.

Important items involved in a 1031 Exchange:

• Both your old and new property must qualify as 1031 property.
• You have 45 days after the closing to prepare a list of properties you want to buy
• You have 180 days after the closing to acquire one or more of the properties on your 45-day list.
• You may not touch the money. Typically the money is held by a Qualified Intermediary who must be used to facilitate the transaction to meet the IRS requirements for an exchange.
• The holder of title to both your old property and your new property must be identical.

There are various types of exchanges that can be executed. The most common is the Delayed Exchange where the relinquished property (sold property) is sold and the replacement property (purchased property) is bought within the time limits. You can also have a Simultaneous Exchange where the exchange of two properties occurs the same day and time and with the same closing/escrow company. Then there is the Construction Exchange where you buy raw land and add improvements. 

As of September 15, 2000, the IRS has finally acknowledged the use of Reverse Exchanges. The “Safe Harbor Dates” are the same as those for a Delayed Exchange. This has created an increase in the use of Section 1031 for Reverse Exchanges and allows the taxpayer to purchase the replacement property before the relinquished property is sold. 

The like-kind exchange under Section 1031 is “tax deferred”, not “tax-free”. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

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