For example, single-family rental houses in Idaho can be exchanged for an apartment in Texas, or land in Florida can be exchanged for a commercial building in New York. This flexibility helps property owners realize their investment objectives. By exchanging instead of selling for cash, owners can diversify or consolidate holdings, reduce management commitments, or improve cash flow.

Over the long term, acquiring real estate through exchanges is an excellent method of building wealth. Section 1031 allows continued deferral of taxes on subsequent exchanges, which enables the owner to increase equity without the burden of capital gain taxes.

Basically, the 1031 exchange is the sale of one property followed by the purchase of another. It is critical that funds are held by a "Qualified intermediary.," that both properties are of like kind, and the exchange time period requirements are met.

Contrary to what most property owners envision a 1031 exchange is rarely a simultaneous two party swap. A property is sold by the Exchanger to any Buyer (often called Phase I) the qualified intermediary must be retained prior to this closing. The exchange funds are held safely in the qualified intermediary's exchange account (the IRS stipulates that the Exchanger cannot be in actual or constructive receipt of funds at any time during the exchange).

When Phase I closes, the exchange period begins. The Exchanger has 180 days from the Phase I closing date to acquire the replacement property and must identify the replacement propert(ies) within the first 45 days. Phase II is the acquisition of the like-kind replacement property, which can be closed at any time during the 180 day exchange period.


Reasons to use a Section 1031 exchange

So should you sell your property or should you use the Section 1031 exchange?

There are many ways to build an estate. One avenue is through investing in real estate. Careful consideration is given in selecting apartments, land, warehouses, or other types of investment properties. Likewise, the same consideration should be given when moving to another investment property. Unfortunately many investors do not plan head. They will sell and pay taxes, then acquire other properties. Smart investors will take advantage of another method left to them: The tax deferred exchange!

The tax-deferred exchange allows the investor to defer paying capital gains tax on their investment properties. Conversely, an investment property that is sold without a tax-deferred exchange can force the seller to pay up to 38% of their gain in taxes! In the event of a 1031 exchange, an investor is able to use the money they would have paid in taxes, and put it to work for them in another investment property.

Within an appreciation rate of 10%, it would take the seller four years to reach the value of the exchanger's property. The exchanger clearly has the advantage over the seller who pays taxes and then reinvests.

Reverse 1031

Reverse 1031 exchanges often strike fear in the hearts of legal and tax professionals trying to protect clients who are determined to use this technique to pay as little tax as possible. This is because there has been no formal acknowledgement of reverse exchanged, until now.

In simple terms, a reverse exchange happens when you want to buy the new property before you've sold your old one. There might be a million reasons why you want to do this, but if you don't want to pay tax on the sale of your old property in a reverse exchange, you have to carefully structure the purchase of the new property so that you don't take title to it until after you've closed on the sale of your old property. Typically in a reverse exchange, the qualified intermediary takes title to the new property and holds it for you until your other property closes.

Exchange Definitions

Exchange: The giving of one thing for another. Under section 1031, property held for productive use in a trade or business is exchanged for like-kind property.

Exchanger/Exchangor: The client or taxpayer that takes advantage of the exchange process to defer paying capital gains taxes.

Delayed Exchange: An exchange that takes place with time (a day up to 180 days) in between the initial sale and subsequent acquisition.

Simultaneous Exchange: An exchange that takes place on the same day. Both sale and acquisition properties are exchanged on the same day. Much more popular before the Starker court case.

Starker Exchange: A name derived from the Starker Court Case in 1979 that is used to describe a delayed exchange. The first case that challenged exchanges of property received over a period of 2 years. A transaction is to add sufficient cash to offset the difference in mortgages.

Like-Kind: Property that would qualify for a like-kind exchange under IRC Section 1031. According to the Department of Treasury nontaxable exchanges must meet six conditions:

• Property must be business or investment property.
• The property must not be held for resale.
• There must be an exchange of property for property. It does not matter if city property is exchanged for farm property, or if improved property is exchanged for unimproved property. The exchange of property owned for a lease that runs 30 years or more also qualifies as a like kind exchange.
• The property must be tangible property (i.e., not stocks, bonds etc.)
• The property must meet the 45-day identification requirement.
• The exchange must meet the 180 day completed transaction requirement

Qualified Intermediary: Middleman, facilitator, accommodator, term given to entity making the trade with the taxpayer. Typically hired to convert a sale/purchase into an exchange.

Relinquished Property: Phase I, Down leg, property to be given in an exchange by taxpayer.

Replacement Property: Phase II, Upleg, property received in an exchange by taxpayer.

Direct Deeding: Commonly used to pass property directly from Exchanger to Buyer and then from Seller to Exchanger. The Facilitator receives an equitable interest in the property. Approved by the IRS in the new 1991 regs.

Identification: Within 45 days after the relinquished property is exchanged. Property must be identified in writing typically to the facilitator.

180 Days: Total time allotted to acquire the Replacement Property. Must be one of the properties designated in the Identification period.