THE TAX DEFERRED EXCHANGE

The purpose of a 1031 Exchange is to allow you to defer the capital gains taxes due on the sale of investment real estate when you are also purchasing a replacement property. The tax deferred exchange, as defined in Section 1031 of the Internal Revenue Code of 1986, as amended, offers investors one of the last great opportunities to build wealth and save taxes.  By completing an exchange, the investor (Exchanger) can dispose of their investment property, use all of the equity to acquire replacement investment property, defer the capital gain tax that would ordinarily be paid, and leverage all of their equity into the replacement property.  Two requirements must be met to defer the capital gain tax: (a) the Exchanger must acquire “like kind” replacement property and (b) the Exchanger cannot receive cash or other benefits (unless the Exchanger pays capital gain taxes on this money).

In any exchange the Exchanger must enter into the exchange transaction prior to the close of the relinquished property. The Exchanger and the Qualified Intermediary enter into an Exchange Agreement, which essentially requires that (a) the Qualified Intermediary acquires the relinquished property from the Exchanger and transfers it to the buyer by direct deed from the Exchanger and (b) the Qualified Intermediary acquires the replacement property from the seller and transfers it to the Exchanger by direct deed from the seller.  The cash or other proceeds from the relinquished property are assigned to the Qualified Intermediary and are held by the Qualified Intermediary in a separate, secure account.  The exchange funds are used by the Qualified Intermediary to purchase the replacement property for the Exchanger.

IRC Section 1031 does not apply to exchanges of stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidences of indebtedness, certificates of trust or beneficial interests, or interests in a partnership.

45 Day Rule
 Following the close of escrow on the sale of your old property, you have 45 days in which to identify up to three replacement property.

Three property Rule
 You may identify up to three replacement properties without regard to their fair market value.

200 Percent Rule
 You may identify any number of properties provided that the combined fair market value does not exceed double the value of the relinquished property.

180 Day Rule
 Following the close of escrow on the sale of your old property, you have 180 days in which to close escrow on the purchase of the property that was identified under the 45 day rule.

Reverse Exchange
 It is even possible to make a reverse exchange where the replacement property is purchased prior to the sale of the relinquished property. The rules for this procedure are more complex than for a forward exchange and the fees involved are greater so the forward exchange is the preferred method to use.

NON-TAX REASONS TO EXCHANGE
Generally, investors complete tax deferred exchanges to defer the capital gains tax on the disposition of their investment properties. However, there are many additional underlying reasons an investor might want to exchange one property for another. The motives often fall along standard risk reward or cash flow appreciation scales. These are some of the typical non-tax motives to exchange:

  • Exchange from fully depreciated property to a higher value property that can be depreciated.
  • Exchange from property that cannot be refinanced. For example, moving from vacant land to improved property, which can support a new refinanced loan, and give the client the ability to obtain cash after the acquisition of the replacement property.
  • Exchange from non-income producing raw land to improved property to create a positive cash flow from the rental income.
  • Exchange from a property with maximized or minimal cash flow (an apartment building) to a higher cash flow property (a retail shopping center) to generate a larger cash flow.
  • Exchange from a stagnant or slowly appreciating property to a property in an area with faster appreciation.
  • Exchange for a property or properties that may be easier to sell in the coming years.
  • Exchange to meet the client’s location requirements. For example, the client moves to another state and wants to have their investment property nearby for management purposes.
  • Exchange to fit the lifestyle of a client. For example, a retiree may exchange for a property requiring reduced management responsibility so they can do more traveling.
  • Exchange from several smaller properties to one larger property to consolidate the benefits of ownership and reduce management responsibilities.
  • Exchange from a larger property to several smaller properties. Exchanges can be used to divide an estate among several children or for retirement reasons.
  •  Exchange to a property the client can use in his or her own profession. For example, a doctor may exchange from a rental house to a medical building to use for his/her practice.
  • Exchange from a partial interest in one property to a fee interest in another property.
  • Exchange from a management intensive fee interest in real estate to a professionally managed triple net leased property where the lease, including options, has 30 or more years remaining.

Rincon Business Consultants cannot provide advice regarding specific tax consequences. Investors considering an IRC 1031 tax deferred exchange should seek the counsel of their accountant and attorney to obtain professional and legal advice.

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