SECTION 1031 EXCHANGES - THE BASICS

Jan, 2009

I was recently asked to write a short article for a local publication about the basics of Section 1031 exchanges. It turned out to be a nice summary of the basics of exchanging, so I thought I would repeat it here:

What if there were a way for a real estate investor or business owner to sell assets and reinvest the profits with absolutely no income tax liability whatsoever? A Section 1031 Exchange allows an investor or business owner to do just that. Believe it or not, this option has existed within the US tax code for well over 80 years.

Why exchange? There are many benefits, but the overriding one is the tax savings that allow more of your cornfarm small.jpg

equity to be used in the new property, Example: You sell investment property and realize net proceeds of $100,000. Without an exchange, $30,000 of your proceeds could easily go to taxes, leaving only $70,000 for reinvestment. By employing an exchange, the entire $100,000 can be reinvested with no tax liability. Before you enter into an exchange, it is highly recommended that you consult with your tax or financial advisor to ensure that a 1031 exchange is right for you.

Between 1984 and 1991, many of the modern-day rules and regulations were written into the code. Let's examine the rules that apply to the common exchange.

#1 - The properties must quality. In IRS terms, they must be "like-kind." The easiest way to determine whether two pieces of real estate are like kind is to ask these two questions: "Did I hold the property I am selling as an investment or use it in my business?" and "Do I intend to hold the property I will buy as an investment or use it in my business?" If you can answer, "Yes," to both of those questions, the properties qualify and they are like-kind. Yes, raw land can be exchanged for an apartment building. Rental houses can be exchanged for farmland. The possibilities are endless!

#2 - Establish your intent to exchange. Now that you have determined that the property you are selling and a property you can envision buying will qualify, you must enter into a written agreement with your exchange company to establish your intent to exchange. This must be done prior to the closing of the sale of your property. At closing, as required by Section 1031 regulations, the proceeds are delivered directly to your exchange company to be held in trust during the exchange.

#3 - Identify the property to be purchased. After closing, you have 45 calendar days to identify the property to be purchased. I prefer to explain this rule by saying that you have all of the time before your old property sells and closes plus 45 days after the closing to make the identifications. Generally, you may identify three properties as potential replacement property and you may acquire one, two or all three of those properties. There are no restrictions on the values of the properties, either individually or in the aggregate. There are alternate rules of identification, but most exchangers use the Three-Property Rule.

#4 - Acquire the replacement property. Again going back to the date of closing of the property you sold, you must acquire (close on) your replacement property within 180 days following that date. At closing, the funds in your exchan ge account are paid directly from the exchange company to the closing agent.

This summarizes the most common type of exchange, referred to as a delayed exchange. Other exchange structures are possible, such as reverse exchanges (buy the new property before selling the old one), construction and improvement exchanges (build or improve the new property with proceeds from the sale of the old one), and exchanges of business assets (non-real-estate exchanges).

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It is critical that exchange rules be followed carefully; to do otherwise will cause the exchange to fail. You should align yourself with a qualified exchange company that understands the intricacies of Section 1031 requirements. Employing a company that demonstrates knowledge of exchange regulations, is engaged in the exchange industry on a full-time basis, and supports the industry and the protection of consumers through membership in the Federation of Exchange Accommodators is the best way to ensure a successful result with your exchange.