1031 Exchanges - The Smart Way To Buy Investment Property

Requirements

As you might imagine, the IRS rules governing a 1031 exchange are quite detailed and specific. At a high level however, three conditions must be met to accomplish the exchange:

1. The properties exchanged must "qualify" and be of "like-kind."
   
   The IRS sorts real estate into four classifications: Personal Property (for personal use), Dealer Property (primarily for sale), Business Property and Investment Property. Only the last two - Business and Investment - qualify for 1031 tax deferral; the first two do not. That's the "qualify" part.
   
   "Like-kind" refers to your use of the property (not its grade or quality), and both the property received and the property sold must be of "Like Kind." An investment property exchanged for another investment property, for example, would qualify. Keep in mind as well that it doesn't matter what the other party does or did with the property - it's your use that determines the classification.
   
   
2. The time requirements must be strictly followed.
   
   The replacement property (the one you are planning to purchase) must be "identified" within 45 days of closing on the relinquished property (the one you are selling). In identifying, the replacement property must be unambiguously described (e.g. with a street address or legal description).
   
   Also, the replacement property must be received within 180 days of closing or on the date that the tax return of the taxpayer is due, including extensions, whichever is earlier.
   
   
3. There must be an actual exchange, not a transfer of property for money only.

Two Important Things to Keep in Mind

• Trade Even or Up In Value. The property you wish to acquire should have a value equal to, or more than, the relinquished property. In other words, all of the proceeds from the relinquished property sale should be invested in the replacement property. If you don't do this, the transaction may still qualify as a 1031 exchange, however the unused proceeds (known as "boot") will be taxed on their face value at the capital gains tax rate.
  
  
• Exchange or Sale. Section 1031 requires an actual exchange of properties. If you simply sell your property and reinvest the money in another property - even if it's a simultaneous close - you will not qualify for exchange treatment. This type of transaction will result in something called "Constructive Receipt."
  
  Constructive receipt occurs when you have the funds in a position in which you may draw on them, direct their usage, or give notice of intention to withdraw. In other words, with a 1031, you must not have control of the funds.
  
  One of the primary ways that you avoid constructive receipt is with a written contractual agreement with a Qualified Intermediary. The Qualified Intermediary, for a fee, acts to facilitate the deferred exchange by entering into an agreement to exchange the properties. Under this agreement, the Qualified Intermediary sells the relinquished property, acquires the replacement property, and transfers the replacement property to the exchanger.

This is just a brief overview, and of course there are many more details involved in getting from start to finish with this process. Keep in mind as well that a 1031 tax deferred exchange is not some kind of slick loophole - the government is deliberately subsidizing your purchase as encouragement to keep your money in the marketplace. It truly is a win-win for both you and the IRS.

The bottom line is that with a 1031 exchange, you as the investor have an increase in purchasing power (thanks to the deferral of capital gains tax) with which to buy real estate. Frankly, it doesn't get much better than that.