Introduction to the 1031 Exchange

If you currently own property and are interested in trading up to new property, a 1031 exchange may be right for you. The 1031 exchange is named for the relevant section of IRS code, which allows a taxpayer to avoid capital gains tax when selling a property and replacing it with another "like kind" property. The theory is that if you use the proceeds from selling your property to buy a different property, you have not gained anything that can be used to pay taxes. A 1031 exchange is fairly complicated, but this guide will help you understand the basics.

Like Kind Property
The term "like kind property" can be confusing. 1031 exchanges are generally performed in regards to real estate, which may be commercial or residential property, or even land. In general, if the state in which the property is located considers it to be "real property," then the IRS will as well.

Some personal property can also be the subject of a 1031
exchange. However, very specific guidelines will apply. For example, livestock of the opposite sex are not considered "like kind" property. Contact the IRS at www.irs.gov for more information about allowable personal property.

Greater or Equal Value
In order to qualify for a 1031 exchange, the new property must be of greater or equal value to the property that is sold. Although not an official IRS term, the word "boot" is commonly used in financial circles to refer to additional money or property that is acquired along with the replacement property. If the transaction will result in boot, it will not qualify for a 1031 exchange.

Time Limits
You do not have to complete the sale and acquisition simultaneously. However, you must identify the replacement property within 45 days of the date of sale and close the transaction within 180 days. Holidays do not grant an extension of time. If you fail to meet either of the time limits, the 1031 exchange will not
take effect.

Qualified Intermediary
At no time are you allowed to take possession of the sale proceeds if you wish to perform a 1031 exchange. Instead, the proceeds should go directly to a Qualified Intermediary, who will also become, in effect, the buyer of the new property. Technically, you may appoint virtually anyone with whom you have not had a personal or financial relationship in two years, except in Nevada, where Qualified Intermediaries must be licensed. In practice, however, it is much better to select a Qualified Intermediary company, which is similar to an escrow company but works full-time on the facilitation of 1031 exchanges. Make sure that your firm of choice has no relationship with your bank, attorney, real estate agent or any other relevant body.

How to Proceed
If you are considering a 1031 exchange, your first step should be to retain a CPA or tax professional to guide you through the process. Tax code is extremely complicated, and the
slightest mistake could render your transaction ineligible for the 1031 exchange. Try to retain a real estate agent who is familiar with the process as well.

Be very careful in selecting your replacement property. Remember that if the new property costs less than the original property, you will not be eligible for the exchange. Also ask your tax professional to advise you as to which closing costs on the new property may be paid with proceeds from the original sale. Certain expenses such as utility escrow charges must be paid with personal funds rather than those resulting from the original sale.

A 1031 exchange is a valuable way to avoid paying capital gains taxes on transactions that do not truly result in capital gains. However, the tax code is very specific and leaves no room for error. The information above can be used to help you decide whether your situation may be eligible for a 1031 exchange, but should not be considered official tax advice. Retain a tax professional at the beginning
of the process and follow his or her advice precisely.