What is a 1031 Tax-Deferred Exchange?

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.  A tax-deferred exchange is a method in which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction.  The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax.  In other words, the taxpayer’s investment is still the same, only the form has changed (i.e. vacant land exchanged for apartment building).  Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.  The like-kind exchange under Section 1031 is tax-deferred, not tax-free.  When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

A Qualified Intermediary is an independent party who facilitates tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code.  The QI cannot be the taxpayer or a disqualified person.

• Acting under written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer.
• The QI holds the sale proceeds, to prevent the taxpayer from having actual or constructive receipt of the funds.
• Finally, the QI acquires the replacement property and transfers it to the taxpayer to complete the exchange within the appropriate time limits.

Different Kinds of Exchanges:

• Simultaneous Exchange:  The exchange of the relinquished property for the replacement property occurs at the same time.

• Delayed Exchange:  This is the most common type of exchange.  A Delayed Exchange occurs when there is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property.  A Delayed Exchange is subject to strict time limits, which are set forth in the Treasury Regulations.

• Build-to-Suit (Improvement or Construction) Exchange:  This technique allows the taxpayer to build on, or make improvements to, the replacement property, using the exchange proceeds.

• Reverse Exchange:  A situation where the replacement property is acquired prior to transferring the relinquished property.  The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000.  These transactions are sometimes referred to as “parking arrangements” and may also be structured in ways which are outside the safe harbor.

• Personal Property Exchange:  Exchanges are not limited to real property.  Personal property can also be exchanged for other personal property of like-kind or like-class. 

The Identification Period:  This is the crucial period during which the party selling a property must identify other replacement properties that he proposes or wishes to buy.  It is not uncommon to select more than one property.  This period is scheduled as exactly 45 days from selling the relinquished property.  This 45 day timeline must be followed under any and all circumstances and is not extendable in any way, even if the 45th day falls on a Saturday, Sunday or legal U.S. holiday.

There are three rules that limit the number of properties that can be identified.  The taxpaer must meet the requirements of at least one of these rules:

• 3-Property Rule:  The taxpayer may identify up to 3 potential replacement properties, without regard to their value; or

• 200% Rule:  Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property; or

• 95% Rule:  The taxpayer may identify as many properties as he wants, but before the end of the exchange period, the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.

The Exchange Period:  This is the period within which a person who sold the relinquished property must receive the replacement property.  It is referred to as the Exchange Period under the 1031 Exchange (IRS) Rule.  This period ends at exactly 180 days after the date on which the person transfers the property relinquished or the due date for the person’s tax return for that taxable year in which the transfer of the relinquished property has occurred, whichever situation is earlier.  Now according to the 1031 Exchange (IRS) Rule, the 180 day timeline has to be adhered to under all circumstances and is not extendable in any situation even if the 180^th day falls on a Saturday, Sunday, or legal U.S. holiday.