What is a 1031 Tax Deferred Exchange?

Under Section 1031 of the Internal Revenue Code, 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 term "Like-Kind" does not necessarily mean identical.

A person can do a simultaneous or delayed exchange. Most people do a "three-way" or delayed exchange as it is difficult to find a party who wants to buy ones property and that party owns property that the exchanger is interested in obtaining. What this means is an owner can exchange a rental property or even unimproved raw land for other rental property and not pay any current tax on the gain realized from the disposition of the old property. Caution must be used if improved real estate is exchanged for unimproved raw land. If accelerated depreciation was taken on the old property a recapture tax may be imposed, so says section 1250 (d) (4) of the Internal Revenue Code.

Both properties must be the same kind of property i.e., business for business or investment for investment. This does not apply to dealer or inventory property. As with a sale of principal residence, the exchange must be for property of equal or greater value than the sales price of the property given up.

There are several other conditions which must be met in order to comply with section 1031 regulations. For instance, any cash received from the sale of the old property must not be available at any time to the "exchanger" or seller that will be transferred to the new property. Cash is held in escrow by a neutral third party known as an "accommodator" or "strawman." Also, the exchanger must identify the new property to be acquired within 45 days after the close of escrow on the old property and close escrow on the new property within 180 days after the close of escrow on the old property.

The object of a tax-deferred exchange is obvious. Even if your real estate holdings doubled or tripled in value during your ownership, you would not be subjected to current federal taxation on your gains so long as you exchange it for "Like-Kind" real estate of equal or greater value.

It is very important to any person considering making such an exchange to consult with an experienced accountant or attorney as to the tax and legal implications of doing a 1031 tax-deferred exchange.

(Current laws may have changed some of the rules concerning 1031 Exchange, please consult a legal or tax professional in this field.)