The 1031Exchange goes by different names like 1031 Reinvestment plan, Starker Exchange and Section 1031 Exchange. The main premise behind this part of the tax code is to defer the paying of capital gains.

Basically a real property owner sells his property and then "reinvest" the proceeds by buying another "like-kind" property, thus deferring the capital gain taxes on the sell of the first property. But the transaction must be done in accordance with the IRS guidelines.

Who qualifies for the 1031 Exchange?

Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties.

Who should consider a 1031 Exchange?

Any one who will net a gain upon the sale of an investment property held for more than 1 year. Or a property that has been substantially depreciated for tax purposes and has appreciated in fair market value is a good candidate.

The different structures of a 1031 Exchange

The simplest type of 1031 exchange is a simultaneous swap of one property for another. 

Another type is "Deferred Exchanges" which are more complex but allow flexibility.  They allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties.

To qualify as  a Deferred Exchange it must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction).  Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property.  Taxpayers engaging in deferred exchanges generally use exchange facilitators also known as Accommodator or a Qualified Intermediary, and by using an "exchange agreement" pursuant to rules provided in the Income Tax Regulations.

A Reverse Exchange is somewhat more complex than a deferred exchange.  It involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days.  During this parking period the taxpayer disposes of its relinquished property to close the exchange.

What property qualifies for Like-Kind Exchange?

Both the property you sell and the replacement property you buy must meet certain requirements.

Both properties must be held for use in a trade or business or for investment.   Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.

Both properties must be similar enough to qualify as "like-kind."  Like-kind property is property of the same nature, character or class, like apartments, condos, duplexes, triplex, fourplex, commercial buildings, raw land and rental homes, all considered to same class. 

Time limits to complete a 1031 Deferred Like-Kind Exchange

While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable.  These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.

The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties.  The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary.  However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.

Replacement properties must be clearly described in the written identification.  In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified. 

The second limit is that the replacement property must be received and the exchange completed no later than 180 days (this is strictly enforced by the IRS) after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.

Restrictions for deferred and reverse exchanges

It is important to know that taking control of cash or other proceeds before the exchange is complete will disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable. All cash proceeds of the sale must be reinvested into the replacement property. Any cash that you retain from the sale will be considered taxable income.

If cash or other proceeds that are not "like-kind property" are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange.  Gain may be taxable, but only to the extent of the proceeds that are not like-kind property.

One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete.

You can not act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) can not act as your facilitator.

Also, the replacement property must have an equal level or greater level of debt than the property sold, or the buyer will be subject to paying taxes on the amount of the decrease or will have to put in additional funds to offset the lower level of debt in the replacement property.

As Always, we advise you to should seek professional legal and accounting advice in order to learn all the pros and cons of using a 1031 tax exchange for your use. This page only touches on the main portions of the requirements of a 1031 tax exchange transaction.