1031 / Tax Deferred / Tax Free Exchange

A 1031 Exchange (BFD) is shorthand for Section 1031 of the IRS code of 1986, which states 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 if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Generally, this rule allows for a like-kind exchange of investment property with capital gains taxes being deferred into the future, as long as certain steps are followed within the required timelines and the use of the property is within allowable guidelines.

Many types of property can be used in a 1031 exchange, including raw land, residential or commercial rental, industrial, certain leasehold interests, a farmer’s farm, a doctor’s own office and percentage ownership in investment property. Any real estate for real estate will do, as long as it is held for investment or used in productive trade for business.
Not all properties qualify for a 1031 exchange, however. Properties held by a developer as inventory, dealers in property, securities or other evidence of indebtedness or interest, stocks, bonds &notes, certificates of trust or beneficial interests or any interest in a partnership are all outside the scope of 1031 exchanges and do not qualify for tax-deferred treatment.
In addition, essentially all personal use property will not qualify for 1031 exchange treatment. The safest course of action is to assume that if you use the property for yourself, then you cannot exchange it.

A 1031 exchange has two key timing conditions.
The first condition is that a qualifying like-kind replacement property is “identified” within 45 calendar days of the closing for the relinquished property. The identification requires a written notification to the Qualified Intermediary listing the addresses or legal descriptions of up to three potential replacement properties.
The second condition is that the purchase of the replacement property must be completed within 180 calendar days after the close of the relinquished property. After the 45 calendar days has passed, the exchange may not change their Property Identification List and must purchase one of the listed replacement properties or the exchange fails.
Because of the strict calendar day requirements, after the initial 45 calendar day identification period, the exchange has only 135 calendar days to complete the exchange or else it will fail. Holidays and weekends do not stop the clock. The IRS is very strict on this point and it is a common source of failed exchanges.
The 1031 exchange must show on the same year’s tax return. If the taxpayer is unable to complete the exchange in the same tax year, then the person will have to request an extension to complete the exchange prior to filing your tax return.

The main point of a 1031 tax deferred exchange is that capital gains taxes on real estate held for investment can be deferred indefinitely if the owner of qualifying property exchanges, rather than sells it.
The savings from the exchange will vary by the size of the investment, your own income and other factors (such as state tax rates). Under certain circumstances, this rate can be as high as 20%, with an additional 3.8% passive income tax for high-income households.

Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.

Using a rare straightforward exchange of residential property, we would follow the process of identifying the replacement property, so the entire process of selling the relinquished property, holding the sales proceeds in escrow, transferring the sales proceeds to the seller of the replacement property, who then transfers the replacement property’s deed to the exchange is more or less instant (can occur as multiple closings in one day).

The delayed forward exchange is similar to the simultaneous exchange in general flow: an exchangor sells his property (the relinquished property) to a buyer, whose cash is held in escrow by Southern Exchange Services, acting as the QI under an agreement with the exchangor in this example. When the seller of the replacement property sells to the exchangor, Southern Exchange Services releases the cash to him, and he gives the exchangor the deed to the new property. The difference is that there is a time delay between when the relinquished property is sold and when the exchangor acquires the replacement property (as the exchangor has to identify suitable like-kind property).

The build to suit exchange is more complex than either the simultaneous or delayed exchange because it requires building a new structure or renovating an existing structure that is like-kind to the relinquished property. This construction period generates additional requirements to oversee construction with the funds form the relinquished property sale. Typically this process requires another entity not found in the standard 1031 exchange contracts, an Exchange Accommodation Titleholder (EAT), acting as the Holding Entity, that receives a fee interest in the replacement property to allow it to perform its construction duties using proceeds from the sale of the relinquished property.

In a delayed build-to-suit exchange, the process is essentially identical to that of a build-to-suit exchange, except that a time delay exists between the sale of the relinquished property and the identification and construction start of the replacement property.

The reverse exchange is the opposite of a delayed exchange in that instead of selling the relinquished property first,the replacement property is acquired first, then the relinquished property is sold. This type of exchange has both “safe harbor” and “non-safe harbor”varieties, though the “safe harbor” varieties are more common (in fact, there may be some difficulty with having a non-safe-harbor reverse exchange recognized by the IRS as the regulations are not clear on this point).