1031 tax deferred property exchange is an exchange in which capital gains tax deferral is available to real estate owners who sell their investment, rental, business or vacation real estate, and reinvest the net proceeds in other real estate. Real Estate held for these purposes are called like-kind/1031 properties.
 

This is a major method of avoiding capital gains tax when selling property held for investment or used in a trade or business, such as apartments, rental houses, warehouses, shopping centers, vacant land, and office buildings.

The general rule is to make a tax-deferred exchange, you must trade equal or up in both market value and equity. That means if any cash is taken out of the trade, called “boot” or unlike kind personal property, that boot is taxable to the exchanger. However, the balance of the exchange remains tax-deferred.

Today, most tax-deferred exchanges are made under IRC 1031(a)(3). They are known as Starker delayed exchanges. After the sale of the old property, the Starker exchanger has 45 days to designate the qualifying replacement property of equal or greater cost and equity (known as the “up leg” in the exchange). Meanwhile, the sales proceeds must be held by a qualified third-party intermediary accommodator beyond the “constructive receipt” of the exchanger.

However, the possible disadvantage of tax-deferred exchanges is the investor will be acquiring more rental or investment property. Personal residences and “dealer property,” such as a home builder’s inventory of new houses, are not eligible for tax-deferred exchanges.

To overcome this disadvantage, many long-time investors are making IRC 1031 tax-deferred exchanges for their ultimate dream homes. Since personal residences are not eligible for exchanges, the dream home must be a rental at the time of the exchange. Most tax advisers suggest renting the acquired property at least six to 12 months before making a tax-free conversion to the owner’s personal residence.

However, effective October 22, 2004, Congress said a personal residence acquired in an IRC 1031 tax-deferred exchange via this conversion route cannot use the generous IRC 121 principal residence sale $250,000 or $500,000 exemption until after the residence has been owned at least 60 months. But the homeowner is only required to occupy it for 24 of those 60 months as their principal residence.

Improvement (build-to-suit or construction) exchanges allow an investor to use exchange proceeds to either (1) make improvements to an existing property or (2) build a new replacement property. This variation is extremely popular because it provides the opportunity to purchase properties needing renovation or to acquire bare land and build to an investor's exact specifications. The Qualified Intermediary makes improvements to the replacement property during the exchange period and transfers the improved property back to the Exchanger by the 180th day. Advance planning is essential; normal construction delays, inclement weather and obtaining government permits can make it a challenge to complete the needed improvements within the 180-day exchange period.

 

1031 exchanges can be tricky. You should seek professional advice. We can help.