What is a 1031 Exchange?
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.

The theory behind Section 1031 is that 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. 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.

What are the benefits of a 1031 Exchange?

• A Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties.
• By deferring the tax, you have more money available to invest in another property. In effect, you receive an interest free loan from the federal government, in the amount you would have paid in taxes.
• Any gain from depreciation recapture is postponed.
• You can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.
• The ability to “trade up” to a better property.

1031 Rules

• Replacement property title must be taken in the same name as the title of the relinquished property. This rule applies to a husband and wife and corporations, partnerships, limited liability companies and trusts.
• Like-kind Property
  • To qualify for an exchange under IRC 1031, the replacement property must of “like-kind.” Put simply, property used for trade, business or investment purposes, excluding personal residence. For example: An individual can exchange raw land for a commercial building, or an apartment complex for a retail center. Also, 100% ownership can be exchanged for fractional ownership of property.
• Guidelines
  • The value of the replacement property must be equal to or greater than the value of the relinquished property.
  • The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
  • The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
  • All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
• 45-Day Identification Rule
  • After the closing of the relinquished property, the taxpayer has 45 days to identify the replacement property. No extensions are given if the 45th day falls on a weekend or holiday. More than one replacement property can be identified. The following rules apply:
    • 3 Property Rule: Up to three properties can be identified.
    • 200% Rule: Any number of properties can be exchanged, as long as their aggregate fair market value does not exceed 200% of the fair market value of the relinquished property.
    • 95% Rule: Any number of properties can be exchanged, as long as the fair market value of the received properties, at the end of the exchange period, is at least 95% of the fair market value of the identified properties.
• 180-Day Closing Period
  • The replacement property must be received and exchanged no later than the earlier of 180 days after the transfer of the relinquished property to the qualified intermediary, or the due date (including extensions) of the income tax return for the tax year in which the exchanged property was transferred. No extensions are given if the 180th day falls on a weekend or holiday.
• Boot
  • Boot refers to the “non like-kind” items of personal property and/or cash that are received by the taxpayer in an exchange.
  • Examples of Boot:
    • Cash taken before transfer of property to the QI.
    • Stocks, bonds, notes or partnership interests.
    • Cash proceeds left over after the exchange.
    • Property intended for personal use and not for use by the exchanger in business or investment.