1031s Or Tax Deferred Exchanges

Basically, a 1031 Exchange allows buyers and sellers of investment property or property used in a trade or business to defer capital gains taxes from a property sale indefinitely by rolling the proceeds into another investment or trade or business property of equal or greater value.  In other words, a 1031 exchange equals an interest-free, no term loan from the IRS on the taxes due, both state and federal.

 To fully defer all capital gain taxes, an Exchanger must meet two requirements:

1.    Reinvest all exchange proceeds to acquire like-kind property

2.    Acquire like-kind property of equal or greater value.

The 1031 Exchange, as it is known, has been part of the Internal Revenue Code, in one form or another since 1921.  A series of judicial decisions in the late 1970s and early 80s known collectively as the Starker cases, caused the IRS to create new rules in 1991 that govern 1031 exchanges today.  These rules mandated, among other things, the 45-day time period to identify up to three parcels of property to be purchased; the 180-day time period in which to complete the transaction; and the use of a qualified intermediary to handle the details.

Some Reasons for Doing a 1031 Tax Deferred Exchange

Many investors want to consolidate the numerous properties they own into one or two properties, while some investors want to diversify their investments into multiple properties.

        1031 Exchanges allows the investor to leverage equity in the existing investment and replace it with a more expensive property, thereby potentially gaining a greater appreciation on the new investment.

        Exchanging non-income (raw land) or low-income property for higher-income producing property creates greater cash flow for the investor.

        Numerous investors are ready for retirement and prefer to have their investment property within close proximity to where they retire, allowing for easier and more efficient property management.

        Astute investors will exchange out of a low (tax) basis property into a high (tax) basis property, allowing for large tax write-offs.

        To diversify ones assets, might be one reason to exchange a commercial property for an apartments or an industrial property.

        A 1031 can also aid in estate planning by exchanging one large building for several properties, a different one for each heir.

        Delayed, Reverse and Improvement Exchanges

A delayed exchange is the most common exchange format.  It provides investors up to 180 days to acquire replacement property through the use of a Qualified Intermediary to complete a valid delayed exchange.  The reverse exchange is the purchase of the replacement property prior to closing on the relinquished property structured through the use of an exchange accommodation titleholder. The Improvement (build to suit or construction exchanges allow an investor to use exchange proceeds to either (1) make improvements to a new replacement property or (2) build a new replacement property.

Holding Periods

Some taxpayers wish to convert their former rental house to a principal residence.  In these situations legal and tax advisors recommend that a taxpayer hold a 1031 exchange property for a minimum of at least 12 months.  The reason for this is that a holding period of 12 or more months results in the taxpayer reflecting the property as an investment property in two tax filing years.  In a reverse situation where the taxpayer wishes to convert a residence to a rental, the property owner must have owned and lived in the property for at least 2 out of the last 5 years preceding the sale of the principal residence.

Caveat:  Before you begin the exchange process, make sure to consult with your tax or financial advisor to insure that a 1031 exchange is right for you.

Copyright 2022 Rod Haase.  All rights reserved.