What is an IRC 1031 Tax Deferred Exchange? Sometimes referred to as a Starker Exchange, "Tax Free Exchange" or "Deferred Exchange", the 1031 Exchange is a like-kind exchange of investment property under Section 1031 of the Internal Revenue Code that results in the deferral of capital gains tax liability until your last sale of the investment property.
For example, an investor has held a property for quite a while, depreciating it every year, resulting in a lower tax basis for the property. If the investor sells the property outright it will result in a large capital gain. However the investor can exchange the property for other real estate (of any type and value) and the new property will take the basis of the property the investor exchanged and any gain (other than that considered “boot”) will not be recognized until the new property is sold.
The exchange is really not a "tax free device" but a tax deferral. The rules are complex so care should be taken to make sure that the legal requirements for such an exchange are followed carefully and strictly. A qualified exchange accommodator, legal counsel or tax professional, should be consulted.
Here is a simplified overview of the requirements:
Section 1031 permits a non-recognition of gain only if the following conditions are met:
The relinquished property (property transferred) and the exchange property (replacement property) must be "property held for the productive use in trade, in business or for investment." Neither property can be your principal residence.
There must be an exchange. An exchange is not a sale and subsequent purchase by the owner but must be accomplished through an intermediary in order to qualify.
The replacement property must be of "like kind". All real estate is considered of like kind. In other words, land can be exchanged for a condominium or a farm can be exchanged for a single family home.
Some additional major requirements of a regular exchange:
Identification of the replacement property must be made before the 45th day after the day on which the relinquished property was transferred.
The proceeds from the sale of the relinquished property must be held in escrow by a neutral party until the replacement property is obtained. The taxpayer absolutely can not have access to the funds but can earn interest on them.
The replacement property must be purchased no later than 180 days after the taxpayer transfers his original property, or the due date (with extensions) of the taxpayer's return for the year the transfer was made.
Property located in the United States cannot be exchanged for property outside the United States.
Property received in a like-kind exchange between related persons that is disposed of within two years after the date of the last transfer will not qualify for non-recognition of gain.
A 1031 Exchange is not ideal for everyone so if you are considering one you should contact tax and legal professionals to assist you in making your decision.
This article is intended for informational purposes only. It is strongly recommended that proper advice be obtained from your tax professional, legal counsel or a qualified exchange accommodator. An error in procedure will void the benefits of an exchange and it is NOT POSSIBLE to correct a mistake and turn the transaction back into an exchange.
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