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 WHAT IS A TAX DEFERRED EXCHANGE? 

A tax deferred exchange is simply a method by which a property owner sales one or more properties and buys one or more other properties without having to pay any federal income taxes on the transaction, and often with no state incomes taxes. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property. But in an exchange, the tax on the transaction is deferred until some time in the future, usually when the newly acquired property is sold. This newly acquired property can then be sold and replaced under the same criteria as before, therefore allowing once again for you to put what would have been a check to the IRS to work for your personal benefit. 

The 1031 exchange rules are very specific and are not flexible, so understanding them is crucial. Used correctly they can result in a drastic difference to the bottom line when compared to a traditional sale. Call me and I will explain further how this can work for you.

WHO CAN DO AN EXCHANGE?

Exchanges can be done by individuals, corporations, partnerships, limited liability companies, or any other business entity. 

WHAT ARE THE DISADVANTAGES OF AN EXCHANGE?

The taxpayer must reinvest the net proceeds from the disposition of the relinquished property in like kind property rather than other types of more liquid investments, such as stocks or bonds. There may be additional escrow fees, attorney's fees, accounting fees, and the intermediary’s fees. The replacement property will have a carryover tax basis from the relinquished property. This means that more taxable gain will be realized when the replacement property is sold than would have been realized if the replacement property had been acquired through a straight sale and purchase. There will also be less depreciation deductions if the replacement property is depreciable. 

HOW IS AN EXCHANGE STRUCTURED?

Exchanges may be simultaneous or delayed. In a simultaneous exchange with an intermediary, title to the relinquished property is transferred to the buyer. The buyer pays cash to the intermediary. The intermediary pays cash to the seller who transfers title to the replacement property to the taxpayer. In a delayed exchange, the taxpayer has 45 days to identify the property he or she wants as the replacement property. The taxpayer must acquire that replacement property within 180 days of the transfer of the relinquished property (or the due date of the taxpayer's federal income tax return (including extensions) for the year in which the relinquished property was transferred). There are no extensions or exceptions to these time limits. The other requirements of the IRS regulations must also be met. 

WHAT ARE THE OTHER REQUIREMENTS FOR A VALID EXCHANGE?

There are several requirements for a valid exchange.

1. Types of Property.
In general, all property, both real and personal, can qualify for tax-deferred treatment. However, some types of property are specifically disqualified, namely: property held primarily for sale; stocks, bonds or notes; other securities or evidences of indebtedness or interest; interests in a partnership; certificates of trusts or beneficial interest; and chooses in action (e.g. interests in lawsuits).

In general, all property, both real and personal, can qualify for tax-deferred treatment. However, some types of property are specifically disqualified, namely: property held primarily for sale; stocks, bonds or notes; other securities or evidences of indebtedness or interest; interests in a partnership; certificates of trusts or beneficial interest; and chooses in action (e.g. interests in lawsuits). 

2. The Purpose Requirement.
The taxpayer's relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. Property held or acquired as a personal residence or vacation home will not qualify.

The taxpayer's relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. Property held or acquired as a personal residence or vacation home will not qualify. 

3. The Like Kind Requirement.
Replacement property acquired in an exchange must be "like-kind" to the property being relinquished. All real property is like-kind to other real property. But real property is NOT like-kind to personal property.

Replacement property acquired in an exchange must be "like-kind" to the property being relinquished. All real property is like-kind to other real property. But real property is NOT like-kind to personal property. 

4. The Exchange Requirement.
Section 1031 specifically requires that an exchange take place. That means that property must be exchanged for other property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax deferred transaction from a sale and purchase. Today, deferred exchanges are accomplished through intermediaries to ensure that they meet the exchange requirements of Section 1031.

Section 1031 specifically requires that an exchange take place. That means that property must be exchanged for other property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax deferred transaction from a sale and purchase. Today, deferred exchanges are accomplished through intermediaries to ensure that they meet the exchange requirements of Section 1031. 

HOW DO THE IDENTIFICATION RULES OPERATE?

Whether one or more properties is transferred by the taxpayer as part of the exchange, the number of replacement properties that may be identified within the 45 day period is:

(1) Up to 3 properties, without regard to their fair market value. (The 3 Property Rule);

OR

(2) More than 3 properties, if the total fair market value of all these properties at the end of the 45 day period does not exceed 200% of the total fair market value of all properties relinquished in the exchange (The 200% Rule).

If the taxpayer violates these rules, the penalty is severe; he or she is treated as if no property had been identified. Any property actually received during the 45-day identification period, however, would still qualify for tax-deferred treatment.

WHERE ARE THE FUNDS HELD?

We hold exchange funds in money market accounts. The taxpayer earns the interest on his or her account. Custodial trust accounts are also available for an additional fee for added security for your funds. 

WHAT ABOUT "REVERSE EXCHANGES"?

In a reverse exchange or “parking” exchange, the accommodator or intermediary acquires title to or “parks” the replacement property until the time the taxpayer is able to sell the relinquished property. Alternatively, the taxpayer may acquire the replacement property and simultaneously, transfer title to the relinquished property to an accommodator or intermediary for parking until the relinquished property is later sold to a third party buyer. The IRS has created a safe harbor for these types of exchanges in REVENUE PROCEDURE 2000-37. However, if the parking period goes beyond 180 days, then the exchange is outside of the safe harbor and may be challenged by the IRS. The status of reverse exchanges outside the safe harbor is thus unclear.

2. The Purpose Requirement.
The taxpayer's relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. Property held or acquired as a personal residence or vacation home will not qualify.

The taxpayer's relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. Property held or acquired as a personal residence or vacation home will not qualify. 

3. The Like Kind Requirement.
Replacement property acquired in an exchange must be "like-kind" to the property being relinquished. All real property is like-kind to other real property. But real property is NOT like-kind to personal property.

Replacement property acquired in an exchange must be "like-kind" to the property being relinquished. All real property is like-kind to other real property. But real property is NOT like-kind to personal property. 

4. The Exchange Requirement.
Section 1031 specifically requires that an exchange take place. That means that property must be exchanged for other property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax deferred transaction from a sale and purchase. Today, deferred exchanges are accomplished through intermediaries to ensure that they meet the exchange requirements of Section 1031.

Section 1031 specifically requires that an exchange take place. That means that property must be exchanged for other property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax deferred transaction from a sale and purchase. Today, deferred exchanges are accomplished through intermediaries to ensure that they meet the exchange requirements of Section 1031. 

HOW DO THE IDENTIFICATION RULES OPERATE?

Whether one or more properties is transferred by the taxpayer as part of the exchange, the number of replacement properties that may be identified within the 45 day period is:

(1) Up to 3 properties, without regard to their fair market value. (The 3 Property Rule);

OR

(2) More than 3 properties, if the total fair market value of all these properties at the end of the 45 day period does not exceed 200% of the total fair market value of all properties relinquished in the exchange (The 200% Rule).

If the taxpayer violates these rules, the penalty is severe; he or she is treated as if no property had been identified. Any property actually received during the 45-day identification period, however, would still qualify for tax-deferred treatment.

WHERE ARE THE FUNDS HELD?

We hold exchange funds in money market accounts. The taxpayer earns the interest on his or her account. Custodial trust accounts are also available for an additional fee for added security for your funds. 

WHAT ABOUT "REVERSE EXCHANGES"?

In a reverse exchange or “parking” exchange, the accommodator or intermediary acquires title to or “parks” the replacement property until the time the taxpayer is able to sell the relinquished property. Alternatively, the taxpayer may acquire the replacement property and simultaneously, transfer title to the relinquished property to an accommodator or intermediary for parking until the relinquished property is later sold to a third party buyer. The IRS has created a safe harbor for these types of exchanges in REVENUE PROCEDURE 2000-37. However, if the parking period goes beyond 180 days, then the exchange is outside of the safe harbor and may be challenged by the IRS. The status of reverse exchanges outside the safe harbor is thus unclear.