What Is A 1031 Tax Exhange

May 3

A tax-deferred Exchange is a method that allows a property owner to trade one property for another without having to pay any federal income taxes on the transaction.

In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale. But in an Exchange, some or all of the tax on the transaction is deferred until some time in the future, usually until the newly acquired property is sold. You may also hear these Exchanges referred to as “tax-free Exchanges” because the transaction itself is only partially taxed or not taxed at all.

Exchanges are granted authority under Section 1031 of the Internal Revenue Code (IRC §1031) and related Regulations. When an Exchange is conducted in accordance with the IRC §1031 and the Regulations, the tax on the gain realized in the sale of the old property is deferred (not recognized) until the property acquired in the Exchange is sold or otherwise disposed of in a taxable transaction.

In an Exchange, a property owner simply transfers the old property and receives the new property. However, the Exchange must be structured in such a way that it is, in fact, an exchange of one property for another, rather than the sale of one property and the purchase of another.

A taxpayer is deemed to have sold property in a taxable transaction if the rights and interests in the property are conveyed and the taxpayer is in actual or constructive receipt of the proceeds. For example, a taxpayer who transfers title to property to the buyer and receives the buyers funds, then walks the funds across the street to purchase the new property,  has sold property in a taxable transaction and will not receive the tax benefits of an Exchange.

The taxpayer may avoid the taxable sale and purchase and qualify for Exchange treatment if:

  • Prior to the sale of the old property, the taxpayer enters into an Exchange agreement with a Qualified Intermediary, a fourth-party principal who helps ensure that the Exchange is structured properly and meets all of the requirements of IRC §1031 and the Regulations, and
  • Pursuant to the Exchange agreement, the taxpayer assigns all of his/her rights in and to the sale agreement to the Qualified Intermediary prior to the date of sale, and
  • All of the other requirements of IRC §1031 and the Regulations are met.

Four parties are involved in a typical Exchange:

  • Taxpayer – person who has property and would like to Exchange it for new property. Each Exchange involves just one taxpayer. While there will be tax consequences to everyone involved in the Exchange, our concern is with the taxpayer who will receive the benefits of IRC §1031.
  • Seller – person who owns the property that the Taxpayer wants to acquire in the Exchange.
  • Buyer - person with cash who wants to acquire the Taxpayer's property.
  • Qualified Intermediary – person who facilitates the Exchange by buying and then reselling the properties at an agreed-upon price in return for a fee (he/she never begins or ends the Exchange owning any property). 

Note: The typical Exchange is NOT a swap whereby two individuals swap properties with one another. The party who ends up with the taxpayer's property is NOT the same party who owned the property that the taxpayer will end up with.

The properties involved in an Exchange include:

  • Relinquished Property - the property originally owned by the taxpayer and which the taxpayer will dispose of in the Exchange.
  • Replacement Property - the new property, the property that the taxpayer will acquire in the Exchange. 

For an Exchange to be completely tax deferred, the taxpayer must trade up or equal in value and up or equal in equity. That means that

(1) the replacement property must have a fair market value equal to or greater than the relinquished property AND

(2) all of the taxpayer's equity or more must be used in acquiring replacement property.

Example of a Typical Exchange

Tom (Taxpayer) owns an apartment complex in Tacoma worth $500,000. Because he believes the Tacoma Apartments are no longer appreciating in value, he wants to dispose of them and acquire a larger property, the Boston Apartments, in an Exchange.

Sally (Seller) owns the Boston Apartments, worth $750,000. Because she feels that the Boston Apartments are no longer a good investment for her, she wants to sell the Boston Apartments for cash. She is not interested in buying another property.

Bart (Buyer) would like to buy the Tacoma Apartments for cash.

Through the assistance of Irving (Qualified Intermediary), each party will receive what he/she wants – Tom will own the Boston Apartments, Bart will own the Tacoma Apartments, and Sally will have cash.

The Justification for Tax Deferral

Allowing a taxpayer to defer the tax in an Exchange transaction encourages prudent investments. By deferring the tax due on an Exchange, Congress has given taxpayers the ability to move from one investment directly into another without having to liquidate other investments or settle for less valuable property.

In an ordinary sale transaction, a person sells property for cash. He/She can use a portion of the cash acquired in the transaction to pay tax on the gain. The net proceeds can then be invested in another investment.

But when someone exchanges one property for another property, he/she may not receive cash from the transaction. Therefore, the taxpayer may have no cash available to pay a tax. If taxes were assessed on an Exchange, the taxpayer might have to

  • liquidate other investments to get the cash needed to pay the tax OR
  • exchange into a less valuable property, accept cash for the difference and use the cash to pay the tax

If the tax on a like-kind Exchange were not deferred, exchanging one property for another might result in unwise investment practices.

Learn more about the Advantages and Disadvantages of an Exchange, then call Exchange Authority to find out how we can help you handle the details of this complex transaction.

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