A BRIEF OVERVIEW OF IRC 1031 TAX DEFERRED EXCHANGES
What does investing in real estate have in common with the game of
Monopoly? Winning at both requires acquiring the most valuable real
estate by trading less desirable properties for more attractive ones.
For real estate investors, it's easier to finish a winner by understanding
the benefits of Internal Revenue Code Section 1031 tax deferred exchanges.
Tax deferred exchanges have been a part of the tax code since 1921
and are one of the last significant tax advantages remaining for real
estate investors! One of the key advantages of a 1031 exchange is
the ability to dispose of a property without incurring a capital gain
tax liability, thereby allowing the earning power of the deferred
taxes to work for the benefit of the investor (referred to as an "Exchanger")
instead of the government. IRC 1031 (a)(1) states: "No gain
or loss shall be recognized on the exchange of property held for productive
us 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
used in a trade or business or for investment."
BASIC TAX DEFERRED EXCHANGE REQUIREMENTS
Although many investors mistakenly believe an exchange is a "swap"
of properties, most exchanges completed now are variations of a "delayed"
exchange. By employing what the IRS calls a "Qualified Intermediary",
the procedure simply converts a sale and subsequent purchase of investment
real estate into a tax deferred exchange.
REQUIREMENT #1: Both the sale property ("relinquished" property)
and the purchase property ("replacement" property) must or used in
a trade or business or held for investment to be considered "like-kind"
property. Examples of properties which are clearly not like-kind are
an investor's primary residence or property "held primarily for sale".
Examples of qualifying "like-kind" properties are shown below:
- Stewart owns two rental houses in Nevada. He can perform an
exchange and acquire small apartment building in Washington
- Sarah owns five acres of developable land in Kansas. She can
exchange this land and acquire a vacation rental in Florida, and
not pay taxes on the gain from her Kansas property.
: The IRS requires an investor to identify the
replacement property(s) within 45 days from closing on the sale of
the relinquished property. The 45-Day Identification Period begins
on the closing date. Exchangers have a number of ways to properly
identify properties. They may identify up to three replacement properties
of any value (Three-Property Rule). Alternatively, they can identify
an unlimited number of replacement properties, if the total fair market
value of all the properties is not more than twice the value of the
property sold (200% Rule). The identification must be made in writing
and the property must be unambiguously described.
: Close on the replacement property by the earliest
of either: 180 calendar days after closing on the sale of the relinquished
property - or -- the tax return due date for the year the property
was sold (unless an automatic filing-extension has been obtained).
: The most common exchange format, the delayed
exchange, requires investors to work with an IRS-approved middleman
called a "Qualified Intermediary." The Qualified Intermediary documents
the exchange by preparing the necessary paperwork (Exchange Agreement),
holding proceeds on behalf of the investor, and creates the exchange
between the investor and the Qualified Intermediary. It is recommended
that an Exchanger work with an experienced and financially secure
: To defer all capital gains taxes, an Exchanger must buy
a property or properties of equal or greater value (net of closing
costs), reinvesting all net proceeds from the sale of the relinquished
property. Any funds not reinvested, or any reduction in debt liabilities
not made up for with additional cash from the Exchanger, is considered
"boot" and is taxable.
Unlike those playing Monopoly, real estate investors don't have to
depend upon a "roll of the dice" to pass GO and collect more money.
Savvy property owners in nationwide are utilizing tax deferred exchanges
to acquire the desirable "Boardwalk" and "Park Place" properties and
win the investment game!