What is a 1031 Exchange?

The Tax Deferred Exchange ("1031 Exchange"), as defined in Section 1031 of the Internal Revenue Code of 1986, as amended, and Section 1.1031 of the corresponding Treasury Regulations, as amended, offers real estate investors one of the last remaining and best tax strategies for preserving the value of an investment portfolio and building wealth. By completing a 1031 Exchange, the investor ("Exchanger") can dispose of their investment property, defer the recognition of capital gain taxes that would ordinarily be paid, and leverage all of their equity to acquire replacement investment property.

1. The transaction must be structured as a 1031 Exchange using proper exchange documentation;
    

2. Both the Exchanger's relinquished property and the replacement property must either be held for investment purposes or used in the Exchanger's trade or business;
    

3. Both the relinquished property and the replacement property must be of "like-kind";
    

4. During a 1031 Exchange, the Exchanger cannot have actual or constructive receipt of the exchange equity;
    

5. The purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property;
    

6. All equity received from the sale of the relinquished property must be used to acquire the replacement property; and
    

7. The debt on the replacement property must be equal to or greater than the debt that was paid off or assumed on the relinquished property. A reduction in debt on the replacement property can be offset with additional cash added to a replacement property purchase by the Exchanger, however, increasing the debt on the replacement property cannot be used to offset a reduction in the exchange equity.

To achieve the best results in a 1031 Exchange, an Exchanger should use a Qualified Intermediary ("QI") to provide the necessary documentation, create the necessary "reciprocal trade of properties", provide a "Safe Harbor" protection against the Exchanger's actual or constructive receipt of the exchange equity, and provide professional input and oversight. A Qualified Intermediary is an independent third party who is not related to, or an agent of, the Exchanger. An Exchanger's failure to follow any of the above rules may result in a disallowance and tax liability. A partial 1031 Exchange, however, may still qualify for a partial tax deferral.

What is the difference between a "1031 Exchange" and a "Sale"?

Essentially, the logistics of exchanging one property for another are similar to the standard sale and purchase scenario, however, the main distinction is that a properly structured exchange provides tax deferral because the Exchanger does not receive the proceeds. In a sale, however, the seller receives the proceeds and must pay taxes to the extent of their capital gain.The economic difference between a "1031 Exchange" and a "Sale" is best demonstrated through a comparison:

*Capital Gain Tax is based on: depreciation recapture tax rate of 25%, Federal capital gain rate of 20%, and hypothetical state tax rate of 9% (capital gain tax rates vary by state and there may be federal tax reductions for state taxes).

The Exchanger who completes a successful 1031 Exchange has considerably more equity from the sale of the relinquished property to reinvest in a replacement property.

Does the 1031 Exchange of Properties Need to Happen Simultaneously?

No, the buying and selling of the investment properties do not need to happen at the same time. In fact, the majority of 1031 Exchanges are "Delayed Exchanges" in which the Exchanger has 180 calendar days (or the due date, including extensions, of the Exchanger's tax return for the year of the relinquished property) from the sale of the relinquished property to acquire their replacement property. Additionally, all potential replacement property(s) must be identified, in writing, within 45 calendar days from the closing of the relinquished property closing.

What are the Reasons and Benefits of Completing a 1031 Exchange? ´ Preservation of Equity
A 1031 Exchange provides real estate investors with the opportunity to defer their Federal and State capital gain taxes. This essentially equals an interest-free, no-term loan on taxes due until the property is sold for cash! Most often, capital gain taxes are deferred indefinitely because many Exchangers continue to exchange from one property to the next, dramatically increasing the value of their real estate investments with each exchange.

´ Leverage Assets
Many investors use 1031 Exchanges to exchange from a property in which they have a high equity position, or one that is "free and clear", into a much more valuable replacement property by leveraging the entire equity from their relinquished property. A larger property produces more cash flow and provides greater depreciation benefits, which therefore increases an investor's return on their investment.

´ Diversification
Exchangers have a number of opportunities for diversification through 1031 Exchanges. One option is to diversify into another geographic region, such as exchanging from one apartment building in San Francisco, California into two apartment buildings - one in Phoenix, Arizona and the other in Dallas, Texas. Another diversification alternative is acquiring a different property type, such as exchanging from a small apartment to a retail strip center.

´ Management Relief
Many investors accumulate multiple rentals over the years. The on-going maintenance and management of this diverse group of properties can be minimized by exchanging these properties for one larger property that is better suited to on-site maintenance and management. Exchanging into a single user commercial building or large apartment complex with a resident manager is a good example of this strategy.

´ Estate Planning
Often a number of family members inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. With astute estate planning the Exchanger can exchange from one large property into several smaller properties. The Exchanger can then designate in their will that each heir will receive a different property, which they can then either hold or sell.

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