How can I defer taxes when I exchange property?

What is a 1031 Exchange of Property?

A 1031 tax deferred property exchange is an exchange in which capital gains tax deferral is available to real estate owners who sell their investment, rental, business or vacation real estate, and reinvest the net proceeds in other real estate. Real Estate held for these purposes are called like-kind 1031 properties.

Property owners may sell like-kind properties and defer taxes on the sale's profits by meeting the requirements of an Internal Revenue Service Code 1031 exchange. The purpose of the 1031 Exchange is to allow sellers of like-kind property to buy replacement property of like-kind within a specific time period and defer taxes.

A successful 1031 exchange allows the investor to reinvest 100% of the equity from the sale of a property into the purchase of a preferred replacement property without recognizing any gain. This type of property sale and reinvestment can either be done through a simultaneous or delayed 1031 exchange. In most cases a 1031 exchange is done as three-party delayed in which an intermediary ensures a reciprocal transfer of the properties and provides a "safe harbor" against the actual receipt of exchange funds. It is extremely important that this process be done correctly and with proper and timely documentation. Otherwise, a taxable event may occur.

Advantages of the 1031 Exchange of Property

A 1031 exchange of property is one of the most powerful tax deferral strategies available to taxpayers. A taxpayer should never have to pay income taxes on the sale of property if the proceeds are to be re-invested in like-kind property. A 1031 exchange of property enables a taxpayer to sell income, investment or business property and replace with like-kind replacement property without having to pay federal income taxes on the transaction.

The sale of property and subsequent purchase of a replacement property does not work properly, there must be an exchange. Section 1031 of the Internal Revenue Code is the basis for tax-deferred exchanges and sets forth the approved procedures for making exchanges that qualify the transaction for deferral of taxes. Let us help you select like-kind property to defer the taxes on the property.

1031 exchanges provide real estate owners with a range of opportunities to meet personal investment objectives including increased leverage, improved cash flow, diversification, reduction of management obligations, geographic relocation and/or consolidation. The tax dollars saved by an exchange may be maximized to increase an investor's overall net worth. Ultimately, the exchange process allows investors to reorganize and improve their real estate portfolios to best suit their unique interests and needs.

Generally, if you exchange business or investment property solely for business or investment property of a like kind, no gain or loss is recognized under Section 1031 of the IRS Code. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.

Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.

Disadvantages of the 1031 Exchange of Property

There may be disadvantages to use of a Section 1031 exchange of property. One disadvantage is a reduced basis for depreciation in the replacement property. The tax basis of replacement property is essentially the purchase price of the replacement property minus the gain which was deferred on the sale of the exchange property as a result of the exchange. You would need to consult an account to determine how disadvantageous this would be to your situation.

Techniques for 1031 Exchanges of Property

There several ways to structure a tax-deferred exchange under Section 1031 of the Internal Revenue Code. The exchange should follow the established safe harbor procedures of the 1991 IRS regulations which include the use of an intermediary, direct deeding, the use of qualified escrow accounts for temporary holding of "exchange funds" and other procedures which now have the official blessing of the IRS. Therefore, the exchanges should be structured so that they are in harmony with the 1991 IRS regulations. As a result, persons making exchanges frequently employ the services of an Intermediary with direct deeding. If you do not have an intermediary, we can help you with your selection.

We recommend that an investor seek advice of an accountant to determine how the alternative of 1031 Exchange of property fits your financial objectives and situation.

Additional Resources

IRS Publication 544, Sales and Other Dispositions of Assets (PDF)

IRS Form 8824, Like-Kind Exchanges (PDF)