Frequently Asked Questions

What is a 1031 Exchange?

A 1031 Exchange (Tax-Deferred Exchange) is one of the most powerful tax deferral strategies remaining available for taxpayers. Anyone involved with advising or counseling real estate investors should know about tax-deferred exchanges, including real estate professionals, lawyers, accountants, financial planners, tax advisors, escrow and closing agents, and lenders. Taxpayers should never have to pay income taxes on the sale of property if they intend to reinvest the proceeds in similar or like-kind property.

What are the advantages of a 1031 Exchange?

The advantage of a 1031 Exchange is the ability for a taxpayer to sell income, investment or business property and replace with like-kind replacement property without having to pay federal income taxes on the transaction. A sale of property and subsequent purchase of a replacement property doesn't work, there must be an Exchange. Section 1031 of the Internal Revenue Code is the basis for tax-deferred exchanges. The IRS issued "safe harbor" Regulations in 1991 which established approved procedures for exchanges under Code Section 1031. Prior to the issuance of these Regulations, exchanges were subject to challenge under examination on a variety of issues. With the issuance of the 1991 Regulations, tax-deferred exchanges became easier, affordable and safer than ever before.

What are the potential disadvantages of a 1031 Exchange?

The disadvantages of a Section 1031 Exchange include a reduced basis for depreciation in the replacement property. The tax basis of replacement property is essentially the purchase price of the replacement property minus the gain which was deferred on the sale of the relinquished property as a result of the exchange. The replacement property thus includes a deferred gain that will be taxed in the future if the taxpayer cashes out of his investment.

What are Exchange techniques?

There is more than one way to structure a tax-deferred exchange under Section 1031 of the Internal Revenue Code. However, the 1991 "safe harbor" Regulations established procedures which include the use of an Intermediary, direct deeding, the use of qualified escrow accounts for temporary holding of "exchange funds" and other procedures which now have the official blessing of the IRS. Therefore, it is desirable to structure exchanges so that they can be in harmony with the 1991 Regulations. As a result, exchanges commonly employ the services of an Intermediary with direct deeding.

Exchanges can also occur without the services of an Intermediary when parties to an exchange are willing to exchange deeds or if they are willing to enter into an Exchange Agreement with each other. However, two-party exchanges are rare since in the typical Section 1031 transaction, the seller of the replacement property is not the buyer of the taxpayer's relinquished property.

What are the basic rules for a 1031 Exchange?

Qualifying property is property (or equipment) held for investment purposes or used in a taxpayer’s trade or business. Investment property includes real estate, improved or unimproved, held for investment or income producing purposes. Property used in a taxpayer’s trade or business includes his office facilities or place of doing business. Real estate must be replaced with like-kind real estate.

Property Which Does Not Qualify For A 1031 Exchange includes:

A personal residence
Land under development for resale
Construction or fix/flips for resale
Property purchased for resale
Inventory property
Corporation common stock
Partnership interests
LLC membership interests
Bonds
Notes
Replacement Property Title Must Be Taken In The Same Name As The Relinquished Property Was Titled. If a husband and wife own property in joint tenancy or as tenants in common, the Replacement Property must be deeded to both spouses, either as joint tenants or as tenants in common. Corporations, partnerships, limited liability companies and trusts must be in title on the Replacement Property the same as they were on the Relinquished Property.

The Replacement Property Must Be Like-Kind:

Improved real estate can be replaced with unimproved real estate.
Unimproved real estate can be replaced with improved real estate.
A 100% interest can be exchanged for an undivided percentage interest with multiple owners and vice versa.
One property can be exchanged for two or more properties. Two or more properties can be exchanged for one Replacement Property.
A duplex can be exchanged for a four-plex. Investment property can be exchanged for business property and vice versa.
As referenced above, a taxpayer's personal residence cannot be exchanged for income property and income or investment property cannot be exchanged for a personal residence which the taxpayer will reside in. See an expanded explanation below of different kinds of real estate interests which are like-kind for real estate exchanges.

Any boot received in addition To like-kind replacement property will be taxable (to the extent of gain realized on the exchange). This is okay when a seller desires some cash or debt reduction and is willing to pay some taxes. Otherwise, boot should be avoided in order for a 1031 Exchange to be completely tax free.

The term "boot" is not used in the Internal Revenue Code or the Regulations but is commonly used in discussing the tax consequences of a Section 1031 tax-deferred exchange. Boot received is the money, debt relief or the fair market value of "other property" received by the taxpayer in an exchange. Money includes all cash equivalents received by the taxpayer. Debt relief is any net debt reduction which occurs as a result of the exchange taking into account the debt on the Relinquished Property and the Replacement Property. "Other property" is property that is non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or "non-qualified property." "Other property" also includes such things as a promissory note received from a buyer (Seller Financing).

A rule of thumb for avoiding "boot" is to always replace with property of equal or greater value than the Relinquished Property. Never "trade down." Trading down always results in boot received, either cash, debt reduction or both. Boot received is mitigated by exchange expenses paid. See The Rules of Boot in a Section 1031 Exchange for a detailed explanation of these rules.

What real estate interests qualify as like-kind for a 1031 Exchange?

The following types of real estate interests are deemed by Congress and the IRS to qualify as like–kind to each other for a 1031 Exchange:

Fee interest
Fractional (tenancy-in-common) interest
Leasehold interest, 30-year plus lease
Easements for conservation
Easements for right of way
Water rights
Mineral Rights
Oil & Gas interests
Transferrable Development Rights
Mutual Irrigation Ditch Stock

What is the role of the qualified intermediary?

The role of the Qualified Intermediary is essential to completing a successful and valid delayed exchange. The Qualified Intermediary is the glue that puts the buyer and seller of property together into the form of a 1031 Exchange. Where such an intermediary (often called an exchange facilitator) is used, the intermediary will not be considered the agent of the taxpayer for constructive receipt purposes notwithstanding the fact that he may be an agent under state law and the taxpayer may gain immediate possession of the money or property under the laws of agency.

In order to take advantage of the qualified intermediary "safe harbor" there must be a written agreement between the taxpayer and intermediary expressly limiting the taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of the money or property held by the intermediary.

A qualified intermediary is formally defined as a person who is not the taxpayer or a disqualified person who enters into a written agreement (the "exchange agreement") with the taxpayer and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer. The qualified intermediary does not actually have to be in the chain of title.

There are no licensing requirements for Intermediaries. They need merely be not an unqualified person as defined by the Internal Revenue Code in order to be qualified. The Code prohibits certain "agents" of the taxpayer from being qualified. Accountants, attorneys and realtors who have served taxpayers in their professional capacities within the prior two years are disqualified from serving as a Qualified Intermediary for a taxpayer in an exchange.