What Is a 1031 Exchange?

Internal Revenue Code Section 1031 allows for the deferment of capital gains taxes that would otherwise have been due if a person trades property held for business use or as an investment for another property to be held for business use or as an investment. CAUTION: Internal Revenue Code Section 1031 Exchanges are complex and can have significant tax and other financial consequences. Consult an accountant or tax attorney experienced in this area before starting the exchange process.

Why Do a 1031 Exchange?
Exchanges are popular among residential income property investors for the following reasons:

1. Move up to a more valuable property without paying taxes on the capital gains.
2. Trade fully depreciated property for an undepreciated one. After 27.5 years a property is considered fully depreciated and loses that tax advantage.
3. Consolidate a number of smaller, self-managed properties into a larger one with professional management.
4. Keep money invested in real estate by selling and buying simultaneously.
5. Relocate real estate investments by selling in one location and buying in another.
   

How Is It Done?
Simply put, you arrange to sell your investment property. You then assign the proceeds of the sale to an entity known as a Qualified Intermediary (facilitator). From the date of the sale, you have 45 days to locate a new investment property for the exchange. The qualified intermediary will then buy the property on your behalf,"exchange" the proceeds in his or her custody from the prior sale for the new property you have selected, then transfer title of the new property to you. All of this must be completed within 180 days of the date of the sale of your property.

The 1031 Exchange in Detail

1. The investor retains the services of tax attorney or CPA experienced in 1031 exchanges. GOLIATH can refer you to a professional to assist you with your specific needs.
2. The investor sells the property with a Cooperation Clause in the sales agreement: “Buyer is aware that the seller’s intention is to complete a 1031 exchange through this transaction and hereby agrees to cooperate with the seller to accomplish same at no additional cost or liability to the buyer.” The escrow officer or closing agent contacts the qualified intermediary and requests the exchange documents.
3. The investor enters into an 1031 Exchange Agreement with the qualified intermediary in which the qualified intermediary is named as principal in the sale of the relinquished property and the subsequent purchase of the replacement property. The 1031 Exchange Agreement must meet with IRS requirements, especially pertaining to the proceeds. Along with the 1031 Exchange Agreement, an amendment to escrow is signed which names the qualified intermediary as the seller. Normally the deed is still prepared for recording from the investor to the true buyer (direct deeding). It is not necessary to have the replacement property identified at this time.
4. The relinquished property escrow closes, and the closing statement names the qualified intermediary as the seller with proceeds going to the qualified intermediary. The funds are placed in a separate account to insure liquidity and safety. The closing date of the relinquished property escrow is day zero of the exchange. The address of the replacement property must be sent in writing within 45 days, and the identified replacement property must be acquired by the investor within 180 days.
5. The investor sends the address or legal description of the replacement property to the qualified intermediary in writing on or before day 45 of the exchange. It must be signed by everyone who signed the 1031 Exchange Agreement, and it may be faxed, hand delivered or mailed either to the qualified intermediary, the seller of the replacement property or his agent, or to an attorney unrelated to the investor.
6. The investor enters into an agreement to purchase the replacement property which includes the Cooperation Clause: “Seller is aware that the buyer’s intention is to complete a 1031 Exchange though this transaction and hereby agrees to cooperate with buyer to accomplish same at no additional cost or liability to seller.” An amendment is signed naming the qualified intermediary as the buyer, and the deeding is actually from the true seller to the investor.
7. When conditions are satisfied, and escrow is prepared to close (prior to the 180th day) per the 1031 Exchange Agreement, the Qualified Intermediary forwards the exchange funds to escrow, and the closing statement names the qualified intermediary as the buyer. A final accounting is sent by the qualified intermediary to the investor showing the funds coming in from one escrow and going out to the other, all without constructive receipt by the investor.
8. Investor files Form 8824 with the IRS (and state forms where applicable) when taxes are filed.

Key Terms
Adjusted Cost Basis – The basis of the new property is the same as the basis (purchase price) of property given up minus any money received by the investor, less depreciation, plus improvements, plus any gain (or minus any loss) recognized on the transaction. If the transaction falls under 1031 (b) or (c) the basis shall be allocated between the properties received (other than money) and for the purpose of allocation, there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange.

Boot – Cash or mortgage debt relief to equalize the exchange transaction and results in a tax liability. Taxed at the normal capital gains rate.

Constructive Receipt – The direct or indirect use or control of exchange funds.

Like Kind – The definition by the IRS of property types that can be exchanged for one another. They must be of “like kind” meaning the same nature or character, even if they differ in grade or quality. Both properties must be located in the United States. For our purposes, this means real property owned as an investment, in active use in a trade or business, or for the production of income.

Qualified Intermediary – The person or corporate entity that controls the exchange.

Relinquished Property – The property being sold by the investor. Also known as down-leg property.

Replacement Property – The new property being purchased with the exchange proceeds from the relinquished property. Also known as up-leg property.

Starker Tax Deferred Exchange – A contract to exchange properties in the future. The investor must identify the property for exchange before closing, identify the replacement property within 45 days of closing, and acquire the replacement property within 180 days of closing. A qualified intermediary must be used to facilitate the transaction.

Sources:
1. Internal Revenue Code Section 1031 (Title 26 IRC § 1031), “Like-Kind Exchanges Under IRC Code Section 1031, ”http://www.irs.gov/newsroom/article/0,,id=179801,00.html (accessed November 8, 2008).
2. U. S. National 1031 Exchange, “1031 Education,” http://www.usnational1031.com/metroportal/Exchange1031/pdf/US_National_1031_WEB_Presentation.pdf (accessed August 24, 2008).
3. Wikipedia.com, “Internal Revenue Code Section 1031,” http://en.wikipedia.org/wiki/Internal_Revenue_Code_section_1031, July 25, 2008.
4. Answers.com “Investment Dictionary: Like-Kind Exchange,” http://www.answers.com/topic/1031-exchange (accessed August 24, 2008). : A “Core” neighborhood tends to mirror the overall trend in the market place. (If the market place is appreciating at 7% per year, so is the Core Neighborhood.)