About1031 Exchanges

As an introductory matter, you should know three things about Section 1031 exchanges: 
 

1. You can exchange your property for new property without now paying federal income tax on that exchange if the requirements of Section 1031 are met.

 

2. The exact structuring of the exchange will depend on, and can be tailored to, your circumstances.

 

3. You should obtain sound legal and tax advice before undertaking a Section 1031 exchange.

(a) Section 1031 allows tax deferral .  

 

Table	Sale and Reinvestment	Section 1031 Exchange
Sale Proceeds	$ 1000.00	$ 1000.00
Tax at 25%	$   250.00	$       0.00
Net Proceeds	$   750.00	$ 1000.00
Amount to Reinvest	$  750.00	$ 1000.00

Section 1031 of the Internal Revenue Code (the "Code") provides property owners a mechanism to exchange property they hold for investment or business purposes in return for property that is "like-kind."  The benefit of a Section 1031 exchange, when compared to a sale of that same property followed by a reinvestment of the after tax proceeds, is that no tax is due on the exchange.  Therefore, engaging in a like-kind exchange permits the property owner to reinvest 100% of the proceeds which would result from a straightforward sale of existing property (the "relinquished property") in the new property that is acquired in the exchange (the "replacement property").  In contrast, an actual sale of the relinquished property followed by the payment of tax would leave only 80% or less of the proceeds available for reinvestment.  Please see our tax deferral page for a comparison of how much more you will have to reinvest by choosing the exchange option.

(b) Qualifying Property.

There are a number of requirements that must be met in order for you to be able to engage in a Section 1031 tax deferred exchange.  Most importantly, both the relinquished property and the replacement property must be held for "productive use in a trade or business" or "for investment."  The "like-kind" property qualifying rules are broad with respect to real estate.  Any real estate property can be exchanged for another real estate property regardless of use.  For example, land can be exchanged for a hotel.  However, the qualifying rules for personal property are more restrictive and focus on the use of the property.  For example, an aircraft can be exchanged for another aircraft, but an aircraft cannot be exchanged for a rail car. 

(c) Excluded Property.

Even if property is held for use in a trade or business or for investment, certain property (including inventory, stocks and securities, and partnership interests) are specifically excluded from eligibility under Section 1031. 

(d) Boot.

To the extent that you receive back cash, net debt reduction or other value in addition to qualifying replacement property (usually referred to as "boot"), you will be subject to tax.

Nonetheless, Section 1031 is a flexible tool in that it allows for personal property exchanges as well as exchanges of real property.  This flexibility enables taxpayers to:

 

-Exchange multiple properties, such as selling two properties and acquiring two, or selling one item of business equipment and acquiring three.

 

-Exchange properties that are not of equal value.  In some instances, this may give rise to a limited tax liability.

 

-In exchanges involving real estate, different categories of business or investment real estate can be exchanged; for example, land can be exchanged for residential property, or commercial property can be exchanged for industrial property.

(e) Alternative structures.

The exact structure of your exchange will depend on your particular  circumstances.

 

(i) It may be that you cannot now locate the replacement property and you will not be able to complete a simultaneous exchange.  Therefore, you may need to complete a "delayed" or "forward" exchange which allows you to transfer your relinquished property today and purchase your replacement property later.  However, the applicable rules require you to meet certain time-lines in completing your acquisition of the replacement property.

(ii) In other circumstances, you may have located the replacement property but have not yet found a buyer for your property.  Here, a reverse exchange is in order. 

(iii) Finally, you may want to receive replacement property that needs to be constructed or improved before it is received by you, and that too can be done through a Construction or Build-to-Suit Exchange.

(f) Getting sound advice.

While the rules governing Section 1031 transactions are important and must be observed in order to complete a successful tax free exchange, Section 1031 transactions can be achieved in most instances provided you receive appropriate advice.   Under the Section 1031 regulations, use of a qualified intermediary greatly enhances the prospects of successfully completing a valid Section 1031 exchange that will be respected by the IRS.  Contact me for details.

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