A tax-deferred exchange is a way for property owners to trade one property for another without having to pay any federal income taxes on the transaction. 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 sometime in the future, usually when the newly acquired property is sold.

There are very specific requirements that you must follow so that your sale transaction will qualify for tax deferred exchange treatment under Section 1031 of the Internal Revenue Code. For these reasons, it is important that you consult with your financial advisor, tax advisor, and attorney when making decisions about this type of transaction.

1031 Tax Deferred Exchange Requirement

The sale and the purchase transactions must be structured properly in order to qualify for tax-deferred treatment under a 1031 exchange.  This requires a Qualified Exchange Intermediary who will complete the necessary legal documents to ensure that you are in compliance will all laws, regulations and rulings.

It is critical that the purchase and sale agreement be assigned to the Qualified Exchange Intermediary prior to the close of your sale transaction and prior to the close of your purchase transaction.  Your transaction will not qualify for 1031 exchange treatment if either transaction closes without the assignment of the purchase and sale agreement into your Qualified Exchange Intermediary in both transactions.

Reinvesting or Replacing Your Investment Values

You must acquire one or more replacement properties that are equal to or greater in net purchase value than the net sales value of the relinquished property you sold.  You must reinvest all of your net cash proceeds from the sale of the relinquished property.  Additionally, you must replace the debt that was paid off on the sale of the relinquished property with an equal amount of debt on the like-kind replacement property.

You can always add more cash into your purchase of your like-kind replacement properties, but you can not pull any cash out of the sale of your relinquished property without incurring depreciation recapture and/or capital gain income tax liabilities.

Qualified Use Requirement

Your relinquished properties and your like-kind replacement properties must have been held as rental or investment properties or used in your trade or business.  The critical issue is that you must have had the intent to hold the properties for investment purposes and not have held them for sale (i.e., inventory in your business).

Like-Kind Property Requirement

There is a lot of misinformation regarding what constitutes like-kind replacement property.  It is not true that if you sell a townhome you must buy a townhome, etc., as long as your relinquished and replacement properties meet the qualified use requirement discussed above. Any kind of real estate held for investment is like kind to any other kind of real estate that is also held for investment.

1031 Exchange Deadlines

There are very specific deadlines in a 1031 exchange.  You have 45 calendar days from the close of the relinquished property transaction to identify potential like-kind replacement properties being considered for purchase and an additional 135 calendar days — for a total of 180 calendar days — to complete the 1031 exchange by acquiring some or all of the identified like-kind replacement properties.

A 1031 Exchange Example

To understand the powerful protection a 1031 exchange offers, consider the following example:

  • An investor has a $400,000 capital gain and incurs a tax liability of approximately $140,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. Only $260,000 in net equity remains to reinvest in another property.
  • Assuming a 25% down payment and a 75% loan-to-value ratio, the investor would only be able to purchase a $1,040,000 replacement property.
  • If the same investor chose to exchange, however, he or she would be able to reinvest the entire gross equity of $400,000 in the purchase of $1,600,000 replacement property, assuming the same down payment and loan-to-value ratios.

As the above example demonstrates, 1031 exchanges allow investors to defer capital gain taxes as well as facilitate significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the Section 1031 code. For instance, an accurate understanding of the key term "like-kind"—often mistakenly thought to mean the same exact types of property— can reveal possibilities that might have been dismissed or overlooked. 

Contact Us About Your 1031 Exchange

1031 Exchange, LLC and its counsel, Alperin Law, are your resources to obtain accurate and thorough information about the entire 1031 exchange process. We would welcome the opportunity to work with you on your next 1031 exchange. Give us a call at 757-500-2372 to schedule your consultation.