The tax deferred exchange, as defined in Section 1031 of the Internal Revenue Code of 1986 offers investors a great opportunity to build wealth and save taxes. Through a 1031 exchange, investors may sell investment property and purchase replacement investment property using all of the equity realized in the sale by deferring the capital gains tax and depreciation recapture that would ordinarily be due. The effect is as if the government were to offer investors an interest-free loan of their tax liability. Investors can use this “loan” to build more equity until the deferred taxes are due.

Two key requirements must be met to defer the capital gains tax: (a) the investor (or exchanger) must acquire “like kind” replacement property and (b) the exchanger cannot receive cash proceeds from the sale, or any other benefits, without incurring tax liability. To qualify for tax deferral, the proceeds of the sale must flow through a Qualified Intermediary (QI), a specialized type of escrow company. To that end, the exchanger must act prior to the close of the sale of the investment property, entering into an exchange agreement with a QI.

An Exchange Agreement effectively requires that (a) the Qualified Intermediary acquire the relinquished property from the exchanger and transfer it to the buyer by direct deed from the exchanger and (b) the Qualified Intermediary acquire the replacement property from the seller and transfer it to the exchanger by direct deed from the seller. The cash or other proceeds from the relinquished property are assigned to the Qualified Intermediary and are held in a separate, secure account. The exchange funds are used by the Qualified Intermediary to purchase the replacement property for the investor.

Important Considerations for an Exchange

• Exchanges must be completed within strict time limits. The exchanger has 45 days from the date the relinquished property closes to “identify” potential replacement properties. This involves a written notification to the Qualified Intermediary listing the addresses or legal descriptions of the potential replacement properties. The purchase of the replacement property must be completed within 180 days after of the close of the relinquished property. After the 45 days has passed, the exchanger may not change their Property Identification list and must purchase one of the listed replacement properties or the exchange fails!

• To avoid the payment of capital gain taxes the exchanger should follow three general rules: (a) purchase a replacement property that is the same or greater value as the relinquished property, (b) reinvest all of the exchange equity into the replacement property and (c) obtain the same or greater debt on the replacement property as on the relinquished property. The exchanger can offset the amount of debt obtained on the replacement property by putting the equivalent amount of additional cash into the exchange.

• The exchanger must sell property that is held for income or investment purposes and acquire replacement property that will be held for income or investment purposes.

• IRC Section 1031 does not apply to exchanges of stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidences of indebtedness, certificates of trust or beneficial interests, or interests in a partnership.