Tax Deferred 1031 Exchange

Internal Revenue Code Section 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 of like-kind which is to be held either for productive use in a trade or business or for investment"

The TIC industry has expanded rapidly since 2002 when the IRS issued Revenue Procedure 2002-22.



The Tax Deferred Exchange



The tax deferred exchange as defined in Section 1031 of the IRS Code of 1986, as amended, offers investors the opportunity to continue to build their property portfolio while deferring taxes. By completing an exchange, the investor (Exchanger) can dispose of their investment property, use all of the equity to acquire replacement investment property, defer the capital gains tax on property appreciation and recapture of depreciation¹ that would ordinarily be paid, and leverage all of their equity into the replacement property. Two requirements must be met to defer taxes:

a. The Exchanger must acquire "like kind" replacement property with title on the replacement property held identically to that on the relinquished property.

b. The Exchanger cannot directly receive cash or other benefits during the exchange transaction (unless Exchanger pays taxes on this money).

Real property can be exchanged for any other "like kind" real property within the U.S. or its possessions if both the relinquished and replacement properties are held for productive use in a trade or business or for investment purposes. Examples of "like kind" properties that can be exchanged with each other are apartments, commercial office buildings, industrial buildings, warehouses, raw land, and rental homes/condos. For example, raw land can be exchanged for income producing apartments or a warehouse can be exchanged for higher rents from an office building. It is NOT required that raw land be only replaced with raw land or an office building only be replaced with another office building.



Real estate investors can accomplish a wide range of investment objectives using an IRS Code 1031 Exchange, including greater leverage, diversification, improved cash flow, geographic relocation, or property consolidation.



Exchanges must be completed within strict time limits. The Exchanger has 45 days from the date of the relinquished property closing to "Identify" potential replacement properties. This requires a written notification to the Qualified Intermediary listing the addresses or legal descriptions of the potential replacement properties. After 45 days, the Exchanger may not change their Property Identification list and must purchase one of the properties, or the exchange fails.



The Exchanger must acquire the replacement property either within 180 days or the date when the Exchanger must file the tax return (including extensions) for the year of the transfer of the relinquished property, whichever occurs first. Title on the replacement property must be held identically as title on the relinquished property.



Important to Note: There is no extension of the deadlines for Saturday, Sundays or holidays

You may choose among 3 types of identifications:

• 3 Property Rule (most common): Exchanger may identify up to three properties of any value.

• 200% Rule: The Exchanger may identify more than three properties if the total fair market value of what is identified does not exceed 200% of the fair market value of the relinquished property.

• 95% Exception: If the Exchanger identifies properties in excess of Rule 1 and Rule 2, then the Exchanger must acquire 95% of the value of all properties identified.



Exchange Requirements



As a rule of thumb, to defer taxes in an exchange, the investor should always attempt to:

a. Purchase equal or greater in net sales price (value)

b. Reinvest all of the net equity in replacement property.

c. Obtain equal or greater debt on replacement property:

Exception: A reduction in debt can be offset with additional cash from Exchanger but increasing debt cannot offset a reduction in exchange equity.

Types of Exchanges:

The Delayed ("Starker") Exchange is a common type of exchange. Once a property is sold the Delayed Exchange allows the Exchanger the set timeline described above to identify and close on a new investment property while maintaining the ability to continue deferring taxes. Other exchanges include The Simultaneous Exchange, The Reverse Exchange, and the Build to Suit Exchange.

1.  Depreciation recapture defined: Inclusion of part or all of the depreciation you deducted in previous years, in this year's taxable income.  For instance, if you sell or exchange depreciable property at a gain, you may have to report as income all or part of of the gain that is due to depreciation.