1031 Exchange Explained
A tax-deferred exchange represents a simple, strategic method for selling one qualifying property and the subsequent acquisition of another qualifying property within a specific time frame.
Although the logistics of selling one property and buying another are virtually identical to any standard sale and purchase scenario, an exchange is different because the entire transaction is memorialized as an exchange and not a sale. And it is this distinction between exchanging and not simply selling and buying which ultimately allows the taxpayer to qualify for deferred gain treatment. So essentially, sales are taxable and exchanges are not.
Indeed, any property owner who expects to acquire Replacement Property subsequent to the sale of their existing Property should consider a Delayed Exchange. To do otherwise would necessitate the payment of capital gain taxes in amounts that can exceed 20-30%, depending on the appropriate combined federal and state tax rates. In other words, when purchasing Replacement Property without the benefit of a Delayed Exchange, your buying power is dramatically reduced and represents only 70-80% of what it did previously.
There are two basic concepts to a Delayed Exchange. First, the purchase price of the Replacement Property must be equal to or greater than the net sales price of the Relinquished Property. Secondly, all equity received from the sale of the Relinquished Property must be used to acquire the Replacement Property.
Four Common Exchange Misconceptions
- All exchanges must involve swapping or trading with other property owners. (NO) Before delayed exchanges were codified in 1984, all simultaneous exchange transactions required the actual swapping of deeds and simultaneous closing among all parties to an exchange. Often times these exchanges were comprised of dozens of exchanging parties as well as numerous exchange properties. But today, there is no such requirement to swap your property with someone else in order to complete an exchange. The rules have been streamlined to the extent that the current process is reflective more of your qualifying intent rather than the logistics of the property closings.
- All exchanges must close simultaneously. (NO) Although there was a time when all exchanges had to be closed on a simultaneous basis, they are rarely completed in this format any longer. In fact, a significant majority of exchanges are now closed as delayed exchanges.
- Like-kind means purchasing the same type of property which was sold. (NO) The definition of like-kind has often been misinterpreted to mean the requirement of the acquisition of property to be utilized in the same form as the exchange property. In other words; apartments for apartments, hotels for hotels, farms for farms, etc. However, the true definition is again reflective more of intent than use. Accordingly, there are currently two types of property that qualify as like-kind:
- Property held for investment, and/or
- Property held for a productive use in trade or business.
- Exchanges must be limited to one exchange and one replacement property. (NO)This is another exchanging myth. There are no provisions within either the Internal Revenue Code or the Treasury Regulations that restrict the amount of properties that can be involved in an exchange. Therefore, exchanging out of several properties into one replacement property or vice versa, relinquishing (selling) one property and acquiring several, are perfectly acceptable strategies.