Tax Savings: A §1031 exchange allows you to exchange your property for another deferring the payment of federal capital gains taxes. The full amount of relinquished property net equity proceeds may be reinvested, rather than after-tax proceeds.
Increase Income: An example of this would be exchanging out of non-income producing raw land into income producing rental property.
Increase Leverage: The investor benefits in two ways with regard to increased leverage; first, by deferring the payment of capital gains tax the investor has in effect a larger equity in the replacement property; second, the §1031 exchange allows the investor to spread equity over multiple properties using smaller down payments and financing leverage, thus optimizing potential appreciation.
Geographical location change to solve management problems: Investors often accumulate several single-family residences over the years, sometimes in varying geographical locations. This may be management-intensive and time-consuming. Multiple properties may be exchanged for one larger property with on or off-site management. The investor can also move investments closer to their base of operations. This can also assist the investor in long range estate planning.
Diversification and Optimization of Investment: The Investor can exchange one property for several properties in different locations achieving geographical diversity. Also, the Investor might exchange a property in a slower growing area for one in a quickly appreciating market.
Increased Depreciation: When the investor "trades up" in value, using his net equity to purchase a more expensive improved property, the result is usually an increase in the depreciation the investor can claim in future income tax filings.

What is the difference between an exchange (the tax-deferral concept) and a sale?

A sale is an exchange of real property for cash. Since the Investor has receipt of the cash proceeds, a sale does not meet the requirements for a tax-deferred transaction. Thus a sale is subject to capital gains tax.

Isn't tax-deferred the same thing as tax-free?

No. A §1031 Exchange defers the payment of capital gains tax on your relinquished property. The tax basis from this property is carried over to the replacement property. When you finally sell the replacement property, without doing an exchange, you will pay the tax at that time. The good news is that you can repeat this deferral process over and over again, from property to property over a lifetime.

Planning

Can my C.P.A., lawyer, or title company serve as my Qualified Intermediary?

The answer is yes, but only if there has not been a fiduciary (i.e. acting as an agent of the Investor) whereby fees have been paid in the last two years. A title company is exempt from this fiduciary as a result of the payment of title insurance fee. However, many of these professionals hesitate to serve as a Qualified Intermediary for §1031 exchanges as the IRS may interpret them as an agent of the taxpayer.

What are the important provisions of contract special clauses that show initial intent to qualify the agreement for a tax-deferred exchange?

The special clause may be in the form of an ""Addendum to Contract"" identifying the parties, the property address and legal description and signed dated by the parties. It should be attached to the contract before closing. In the contract it may state under Special Clauses: ""See Addendum A attached, and incorporated by reference.""

Can the investor change intermediaries during an exchange?

No, as the mere right to dismiss the intermediary violates the concept of being a Qualified Intermediary. Changing intermediaries would give the taxpayer "an immediate ability or unrestricted right to receive, pledge, borrow or otherwise obtain the benefits of money or other property held by the qualified intermediary." This may cause the entire exchange to become fully taxable.

If my property is in one state, can I trade it for property in another state?

Yes. 1031 exchanges are applicable anywhere in the United States (and the U.S. Virgin Islands). If you are exchanging in more than one locality, state capital gain withholding rules may impact your exchange.

Choosing The Property

Can I buy a partial interest in a bigger property?

Yes. The IRS recently provided rules for acquiring a tenancy-in-common interest with other investors. However, the percentage interest in the acquisition should be specifically delineated on the instrument where the investor receives title.

What property does not qualify for non-recognition of gain or loss in a Section §1031 like-kind exchange?

Real property held for personal use or property held primarily for sale,
Stock in trade or other property held primarily for sale,

The Process

Can the net equity proceeds from the relinquished property closing be held in an escrow account other than with the Qualified Intermediary?

Yes, by prior written agreement, the QI can designate the funds be held in trust in any Qualified Safe Harbor Trust Escrow Account with funds coming directly from the closing agent. The Investor may not have any control of the funds, prior to and during the escrow period.

May more than one relinquished property be exchanged at one time?

Yes. When combined, they are called "The Relinquished Property." Each parcel is completely identified by address and legal description in the Property Exchange Agreement between the investor and the Qualified Intermediary. Many use this pooling of the net equity proceeds to buy larger value replacement properties. There are special rules for Incidental Property involved in a Real Property transaction and the investor should consult their Mutual-exchange, LLC representative.

Does the Qualified Intermediary actually take title to the exchange properties?

Before the delayed exchange became law, the courts approved direct deeding to avoid double closings in multiple property exchanges. The title to a relinquished property buyer and the title to the Investor for the replacement property may be transferred directly rather than to the Q. I. and then to the other party.

After The Exchange

Under what circumstances or conditions may the Investor request and receive the balance of his relinquished property net proceeds from Safe Harbor Escrow?

The Property Exchange Agreement stipulates no refund may be made until after the 45-day identification period has passed. If no identification of replacement property is made, the net equity funds may be refunded, and the exchange is void.
After the 45th day, the net equity funds should remain in Safe Harbor Escrow until closing of all identified properties, or until the full 180-day deadline. Hardship exceptions are allowed, as an identified property's inability to close.
Upon the last replacement property closing, any net equity proceeds balance in Safe Harbor Escrow may be refunded.

Can I lease my replacement investment property out to a family member?

This is a situation where you would need to carefully document your lease and establish a fair market price of rent. Doing this and consulting your tax advisor will protect you from negative tax consequences.

Time Restrictions

When is it too late to begin a §1031 exchange?

If the Investor's original intent to exchange is not documented and delivered prior to closing, and if the transaction has closed, it is too late to accomplish a tax-deferred exchange. There have been examples of closings delayed, by the parties' mutual agreement, allowing the exchange documents to be delivered to closing and the settlement statement modified accordingly.

Are there any exceptions to the 45-day and 180-day time restriction rules?

Failure to identify and/or close the replacement property voids the exchange. Exceptions have been granted by limited extension of the time restraints pursuant to Presidential Declared Disaster events such as hurricane disruptions of commerce. Otherwise, there are no exceptions, even under hardship conditions, further confirmed by court ruling.

Is there a minimum holding time for ownership of either the relinquished or the replacement property?

Yes, a general rule is to hold the investment property for at least 12 months, plus additional days to span two tax-reporting periods. Two years is acceptable.

What is the time restriction placed on exchange transactions?

Time restrictions begin with the date of the first relinquished property closing and all replacement property must be acquired within 180 days. Within 45-days from the first relinquished property closing, the Investor must identify by contract or by written notice the replacement property(s). It should be noted the replacement property must be acquired by the Investor's tax reporting date or he must file and have accepted an extension with the Internal Revenue Service.

Homestead Related

Will an exchange qualify for tax-deferral with the intent to hold a residential replacement property for investment with possible later conversion to homestead?

Yes. Filing the IRS Form #8824 showing transfer of basis, actually renting the property for a reasonable time, reporting income, expenses and depreciation should be sufficient to prove holding for investment. Later, the residence could be converted to personal homestead use by the investor.

Will an exchange qualify for tax-deferral with the intent to convert a residential replacement property to homestead use?

No. The intent must be to hold the replacement property for investment purposes.

Finance

What is a common error by the Investor when solving the mortgage relief problem for the second leg replacement property closing?

Not communicating with the mortgage lender and the closing agent as to the approximate new loan balance necessary to offset the old loan debt. If the new lending balance is sent to closing resulting in surplus funding, any cash back at closing is a taxable event.

Can a relinquished property be exchanged whereby the investor agreed to carry back a purchase money note and mortgage (trust deed)?

Yes. During the delay period the note must not be delivered to the investor, but be held in Safe Harbor Trust or assigned to the Qualified Intermediary as payee to prevent constructive receipt of cash or boot. Any payments under the terms of the note must be deposited in Safe Harbor Escrow. Some of the investor's options then include:

What is the significance of mortgage debt in an exchange?

In an exchange, when the existing mortgage debt (or other liens) on the relinquished property are assumed or satisfied as part of the purchase by the Buyer, the balance of this debt is ""relieved"" (i.e. ""received"") as to the Investor, thus the term ""Mortgage Relief"" applies.

IRS Reporting

When may the investor report interest received to the IRS?

The Investor reports interest earned and received in the same reporting year as the relinquished property closing. If interest is received after the reporting year of the relinquished property closing, then the taxpayer has an option as to which year to report the interest earned to IRS.

How is an exchange reported to the IRS?

Closing agents report an investment real estate transaction on IRS Form #1099, the same as a "sale." The Investor must wait until the exchange transaction has been completed before filing a tax return. If filing due date has passed, the Investor must have filed for an extension before the due date. For the same year as the relinquished property closing, the taxpayer reports the exchange transaction as tax-deferred on IRS Form #8824. This form accounts for the name entity of the Investor, related party transfer, tracks the time restraints, accounts for unlike property (if any), realized gain and recognized gain (if any). It shows the transfer of basis into the replacement property. For improved replacement property, the new depreciation schedule is reported on IRS Form #4562.

Multiple Parties' Ownership and Trusts

Who carries out the tax-deferred exchange on behalf of a trust?

The trustee carries out the tax-deferred exchange and NOT beneficiaries of the trust. The trustee carries out the exchange on behalf of the beneficiaries.

We are in a partnership and want to sell our property. Can we go our separate ways in an exchange?

No, you must exit and exchange in the same manner you enter it. To qualify, you must first formally dissolve the partnership and deed out the interests as tenants-in-common before you do an exchange. Then you can sell/exchange your interests separately.

Will interest in a real estate investment partnership or trust qualify as a replacement investment property in a §1031 exchange?

Yes, as long as it is an investment in tenancy-in-common real estate, and not stock or share ownership. Often an investor may identify this type of investment as replacement property to solve management problems. Investor and/or Counsel should review the investment documents for minimum investment requirements, structure of the investment and applicability.

If two of us own one piece of property and I want to go forward in a §1031 exchange, but my co-owner wants to take his money, is that allowable?

It depends. Yes, if you own the property as tenants-in-common. However, your co-owner is subject to the tax on their capital gain. Partnerships and other legal entities (e.g., LLC's, Corporations) are subject to different rules (see below).