Explanation of Section 1031 Exchanges

Section 1031 of the Internal Revenue Code allows a method whereby an investment property owner can exchange one property for another and defer or postpone the tax due on the gain realized on the transaction. This tax is usually deferred until the newly acquired property is sold. I.R.C. Section 1031 states: “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.”

In 1031 exchanges, a property owner sells one property (relinquished property) and re-places it with another property (replacement property). To qualify for tax deferment, these transactions must be structured so that they are actually exchanges and not simply the sale of one property and the purchase of another property. Usually a taxpayer finds a buyer for the property that is being disposed of and then locates another party who wishes to sell a suitable property for the replacement property. Including the use of a qualified intermediary to assure that the exchange is structured properly results in the involvement of four parties in most exchanges. These four parties are the taxpayer desiring to do an exchange, the buyer of the taxpayer’s relinquished property, the intermediary and the seller of the replacement property that the taxpayer wishes to acquire. The typical exchange is not a swap between two individuals, two party exchanges are rare.

Exchanges under Section 1031 are intended for investment or income producing property and should not be confused with the rollover of your principal residence as allowed under Section 1034 of the I.R.C. This regulation allows a taxpayer to defer the tax due on the gain realized from selling a residence by buying a new residence within two years of selling the old one.

Section 1031 exchanges may appear complicated, restrictive and difficult to accomplish but with the proper assistance they can be accomplished rather simply.

Four-Party Exchanges: These exchanges employ the services of an intermediary to facilitate and structure the exchange. There are two types: the Simultaneous and the Delayed or Deferred.

1. Simultaneous Exchange (Facilitated): In this type the taxpayer transfers title to the relinquished property to the intermediary and the buyer purchases the property from the intermediary. The intermediary then uses these funds to purchase the replacement property from the seller. Title to the replacement property is transferred by the intermediary to the taxpayer. These transfers all occur simultaneously.

2. Delayed Exchange (Facilitated): This exchange is the same as a Simultaneous Exchange except that the stages of the transaction are delayed or deferred. This type is used when the taxpayer has not identified the replacement property at the time of the transfer of the re-linquished property. The intermediary holds the funds generated by the transfer of the relinquished property to the buyer until such time as the taxpayer has identified the replacement property. This identification must occur within 45 days of the transfer of the relinquished property and the transfer of the replacement property must close within 180 days of that first transfer.