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1031 Tax Exchange   

A §1031 tax exchange, also referred to as a tax deferred exchange, gives investors a way to sell one property and acquire another like property without paying federal capital gains taxes (most state capital gains taxes are also deferred).  Provided the exchange meets §1031 criteria, the taxes are deferred until a future time.

It is important to note that this is not a tax-free exchange, merely a deferral.  This deferment can continue indefinitely, provided certain criteria are met.  An investor may continue to exchange, thus continuing deferment.  Additionally, if an investor refinances a property they own (preferably the replacement property), they may obtain a portion of their accumulated equity.  If an investor continues to exchange until death, all capital gain tax is forgiven and the heirs inherit the property in question at fair market value (barring other considerations).

There are three basic rules for deferral of capital gains tax under a §1031 tax exchange.  First, the property being purchased must be of equal or greater value (net sales price) than the original property.  Second, all net equity must be reinvested into the replacement property.  Finally, the replacement property must leave the investor with equal or greater debt than the original property.

1031 also allows an investor to choose a replacement property using any of the following rules.

• Three Property Rule: Three properties, irregardless of value
• 200% Rule: Any number of properties, provided the aggregate fair market value does not exceed 200% of the fair market value of all relinquished property
• 95% Rule: Any number of properties, regardless of the combined fair market value, so long as 95% of the value of the identified properties is obtained.

In the words of IRC §1031, “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property like-kind which is to be held for productive use in a trade or business or for investment.”

Naturally, the benefits of a tax-deferred exchange can be significant.  An Investor can use more equity to acquire investment properties.  An exchange can also be used to leverage, consolidate or diversify assets.  An exchange also gives investors the opportunity to:

• Improve their cash flow
• Reposition their assets
• Invest in different property types (diversify)
• Consolidate property types
• Increase buying leverage
• Increase depreciation deduction
• Reduce management obligations
• Provide for estate and retirement planning
• Allow for relocation
• Eliminate or create joint ownership
• Defer phantom gain on problem properties
• Construct improvements on a property

IRS regulations can be very complex, so it is highly recommended that investors consult a legal and/or tax advisor prior to initiating a §1031 tax exchange.

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