What Is A 1031 Deferred Tax Exchange?

A tax deferred exchange is a simple, strategic method for selling one qualifying property and the subsequent acquisition of another qualifying property within a particular time frame.

While the logistics of selling a property and buying another one are practically identical to any standard sale and purchase scenario, an exchange is different for the reason that the whole transaction is memorialized as an exchange and not a sale.  And it is this difference between exchanging and not just selling and buying which eventually will allow the taxpayer to qualify for a deferred gain treatment.  Thus basically, sales are taxable but exchanges aren't. 

Internal Revenue Code, Section 1031 

Since exchanging represents an IRS-recognized approach to the deferral of capital gain taxes, it is essential for us to appreciate the components and intent underlying such a tax deferred or tax free transaction.  It is in Section 1031 of the Internal Revenue Code that we can find the core essentials required for a successful exchange.  Furthermore, it is within the Like-Kind Exchange Rules, formerly issued by the Department of the Treasury, where we can find the specific interpretation of the IRS and the generally accepted standards and rules for completing a qualifying transaction.  For the rest of this booklet we will identify these rules and requirements.  However, it is important to take into account that the Regulations are not the law.  They only reflect the interpretation of the law (Section 1031) by the Internal Revenue Service. 

Why exchange? 

Any property owner or investor who is planning on acquiring replacement property following the sale of his current property should think about an exchange.  Doing otherwise would necessitate the payment of capital gain taxes in quantities which could go over 20-30%, dependent on the proper combined federal and state tax rates.  Put differently, when you purchase replacement property without benefiting from an exchange, your buying power is significantly decreased and will represent only 70-80% of what it did previously. 

Basic 1031 exchange rules 

Let’s look at a basic concept that applies to all exchanges.  Use this concept to fully defer the capital gain taxes realized from the sale of a relinquished property: 

1.   The purchase price of the replacement property has be equal to or greater than the net sales price of the relinquished property, and 

2.   All equity obtained from the sale of the relinquished property must be used to acquire the replacement property. 

To the extent that any of these rules is abridged, a tax liability will accrue to the Exchangor.  If the replacement property purchase price is less, there will be tax.  To the extent that not all equity is moved from the relinquished to the replacement property, there will be tax.  This doesn’t mean that the exchange will not qualify for these reasons; partial changes do in effect qualify for partial tax deferral.  It just means that the amount of any discrepancy will be taxed as boot, or non-like-kind, property. 

Four common exchange misconceptions: 

1.   All exchanges must involve swapping or trading with other property owners.  (NO) 

Prior to the codification of delayed exchanges in 1984, all simultaneous exchange transactions required the actual swapping of deeds and simultaneous closing among all parties to an exchange.  Often times these exchanges consisted of dozens of exchanging parties on top of several exchange properties.  But today, there isn’t this requirement of swapping your property with someone else with the purpose of completing an exchange.  The rules have been streamlined to the point that the existing process will reflect more on your qualifying intent instead of the logistics of the property closings. 

2.   All exchanges must close simultaneously.  (NO) 

Even though there used to be a time when all exchanges were required to be closed on a simultaneous basis, they are hardly ever completed in this format any more.  As a matter of fact, a significant majority of exchanges nowadays are closed as delayed exchanges. 

3.   Like-kind means purchasing the same kind of property that was sold.  (NO) 

The definition of like-kind has regularly been misinterpreted to mean the requirement of the acquisition of property to be utilized in the same form as the exchange property.  In other words, apartments for apartments, hotels for hotels, farms for farms, etc.  However, the right definition is again reflective more of intent than use.  Accordingly, there are presently two kinds of property that can qualify as like-kind and they are the following: 

- Property held for investment, and/or 

- Property held for a productive use in a trade or business. 

4.   Exchanges must be limited to one exchange and one replacement property.  (NO) 

This is one more exchange myth.  There are no provisions within either the Internal Revenue Code or the Treasury Rules that limit the amount of properties that can be involved in an exchange.  So, exchanging out of several properties into one replacement property or vice versa, relinquishing (selling) one property and acquiring several, are all completely acceptable strategies.