What is a 1031 Exchange?


The 1031 Exchange is a tax-deferred strategy (refering to section 1031 of the IRS tax code) for real estate investors which allows you to avoid income taxes on the sale of a property when the intention is to reinvest the proceeds in a similar or like-kind property. Also called the Tax-Deferred Exchange, it is a long-term strategy with multiple restrictions and benefits. As you’ll see, it can be quite complicated and I recommend that you seek advice from both your Realtor© and tax professional and/or attorney before attempting an exchange. However, the benefits are well worth the effort and it is never too early to begin thinking of tax strategies for your next investment.

The Advantage of a 1031 Exchange is the ability of a taxpayer to sell income, investment or business property and replace with like-kind replacement property without having to pay federal income taxes on the transaction. A sale of property and subsequent purchase of a replacement property doesn't work, there must be an Exchange. Section 1031 of the Internal Revenue Code is the basis for tax-deferred exchanges. The IRS issued "safe-harbor" Regulations in 1991 which established approved procedures for exchanges under Code Section 1031. Prior to the issuance of these Regulations, exchanges were subject to challenge under examination on a variety of issues. Since issuance of the 1991 Regulations, tax-deferred exchanges are easier, less expensive and safer than ever before.

The Disadvantages of a Section 1031 Exchange include a reduced basis for depreciation in the replacement property. The tax basis of replacement property is essentially the purchase price of the replacement property minus the gain which was deferred on the sale of the exchange property as a result of the exchange.

Exchange Techniques.  There is more than one way to structure a tax-deferred exchange" under Section 1031 of the Internal Revenue Code. However, the 1991 Regulations established safe harbor procedures which include the use of an Intermediary, direct deeding, the use of qualified escrow accounts for temporary holding of "exchange funds" and other procedures which now have the official blessing of the IRS. Therefore, it is desirable to structure exchanges so that they can be in harmony with the 1991 Regulations. As a result, exchanges commonly employ the services of an Intermediary with direct deeding.

Exchanges can also occur without the services of an Intermediary when parties to an exchange are willing to exchange deeds or if they are willing to enter into an Exchange Agreement with each other. However, two-party exchanges are rare since in the typical Section 1031 transaction, the seller of the replacement property is not the buyer of the taxpayer's exchange property.

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