1031 Exchanges: A Powerful Tax Strategy for Investors and Business Owners

Internal Revenue Code Section 1031 exchanges enable taxpayers to defer capital gains on the “exchange” of real property held for business use or investment. A 1031 exchange is not a true exchange or swap. Instead, it is the sale of one business use or investment property followed by the acquisition of another. It is much like a typical sale and purchase but with additional paperwork and completed within the time requirements – but with no capital gain taxes due now

A 1031 exchange allows you to accomplish many investment goals, such as acquiring property with greater income potential, less management responsibilities, relocation of an investment, consolidation or diversification, acquisition of a retirement home or future vacation home and an exit strategy for business owners.  

Some of the requirements of a successful exchange are as follows:

  • A qualified intermediary (QI), such as 1031 CORP., is required to facilitate the exchange. Through an exchange agreement, the QI acquires, holds and conveys both properties, controls the sale proceeds and guides the Exchanger through the exchange process.  The QI must be an independent party and cannot be an agent of the Exchanger, such as his attorney, accountant, real estate professional or financial advisor, nor a relative, related party or partner.
  • The Exchanger must not have actual or constructive receipt of the sale proceeds, including deposit monies.
  • Once the relinquished property is conveyed to a buyer, the Exchanger has two important time deadlines that run concurrently and are based on calendar days:
    • 45-Day Identification Period to identify replacement property or properties; and
    • 180-Day Exchange Period to acquire all desired identified replacement property. 
  • To maximize the tax-deferral, replacement property of equal or greater value and equity must be acquired.  In the event of a trade down in value or equity, the Exchanger is taxed on the amount of the trade down. 
  • Any taxpayer, whether individual(s) or an entity, can complete a 1031 exchange but title to the replacement property must be held in the same name as the relinquished property.
  • The basis and depreciation schedule of the relinquished property carries over to the replacement property.  Both are increased by any increase in property value acquired.
  • The 1031 exchange must be set up prior to the transfer of the relinquished property to a buyer.

In addition to the investment objectives already mentioned, an exchange is a great wealth accumulation vehicle and estate planning tool. The fact that one may complete exchange after exchange and continue to rollover the gain allows the gain to be deferred indefinitely. Upon the death of the Exchanger, the heirs inherit the property with a stepped-up basis thus eliminating all deferred gain. Using 1031 exchanges, you have the ability to grow your real estate portfolio with pre-tax dollars and accomplish many short and long-term investment objectives.