While many real estate investors across the United States are aware of the powerful strategy of the 1031 tax-deferred exchange, there are others who are just discovering it – and some who have never heard of it.

What is the 1031 tax-deferred exchange, sometimes also known as the Starker exchange, Delayed exchange, Like-kind exchange, or simply “a 1031″? It is the sale or disposition of property and the acquisition of “like-kind” property following the rules and structure of Section 1031 of the Internal Revenue Code in order to defer federal tax, capital gain, and depreciation recapture taxes. “Like-kind” as applied to real estate is essentially any type of investment real estate, with a few exceptions such as a personal residence. You can sell an office building and buy a retail center or land in a 1031 exchange; you can sell an apartment building and buy an industrial building or hotel.

Defer Capital Gains Tax

Educated investors know they never need pay the tax on their capital gains in the sale of investment real estate IF they intend to reinvest sale proceeds into more investment property. They also know they can DEFER the tax due by reinvesting the proceeds into another investment property. This is not a tax-free transaction – it is a tax-deferral – which can go on indefinitely and for any number of exchanges, until the day an investor or his heirs decide they will cash out and pay the tax. The IRS specifically states in its code:

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

Section 1031 does not apply to exchanges of such items as inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or most other types of assets. However, it does apply to some business and personal property, such as planes, boats, or trucks. For purposes of this article, real estate to real estate is being discussed.

Very detailed I.R.S. rules must be followed in a 1031, with no exceptions. If you break one of the rules, the exchange is disallowed, and you will pay the capital gains.

The day you decide you are going to sell an investment property, you should determine if there will be sufficient capital gain with that “relinquished property” and whether it makes sense to do a 1031 in the first place – if you were planning to reinvest in more investment property or a “replacement property”. Your accountant or attorney can help you determine your capital gains if you cannot.

The Qualified Intermediary

In a 1031, your sale proceeds MUST be held by an independent third party. A “qualified intermediary” (QI) or exchange accommodator is the professional third party who will hold the escrowed funds. If you take possession of the sale proceeds yourself, you will pay the tax. The QI handles the specific necessary paperwork before you sell your property, will hold the funds in trust, and then will transfer the funds for acquisition of your new chosen properties, along with other important details.

Only 45 days to “identify” replacement property

From the day you sell your property, the clock starts ticking. You must “identify” replacement property or properties that you may or will acquire in your exchange no later than 45 days from the day you sold your property. This is done officially through your QI. There are no exceptions to the rules for dates and deadlines, even if specific dates fall on a Sunday or holiday. You then have no later than 180 days from the day you sold your property to close on any or all of your identified replacement property, completing the exchange. The time limits imposed by the I.R.S. are absolutes. If you are one day or one hour late, your trade is disqualified, and you will pay the tax. From time to time in recent history, the IRS has granted extensions to exchangers, for example, to those affected by devastating hurricanes or major earthquake. However, this is rare.

HINT: Find your QI well before you sell your property, and make sure to do a background check or verify the structure of the QI operations (there were some fraudulent QI’s in the news last year and investors lost money). Your broker may be able to make some recommendations. There are many QI companies throughout the United States. Their national association, Federation of Exchange Accommodators (FEA), lists all members on its Web site (1031.org).

TO KNOW:

You have several choices for identification, and your QI will supply the instructions:

The Three Property Rule. Identify up to three properties of any value that you may acquire. Acquire one, two, or all three of the properties. Most choose this option as it is the simplest. It is wise to use all three slots, even if you intend to acquire only one property. You will have backup options in case something goes awry with the first choice.

The 200 Percent Rule. Identify four or more properties, whose value cannot exceed twice (200 percent) of the relinquished property value. Exceeding the 200 percent limit will disallow your transaction. A few choose this option.

The 95 Percent Rule. Identify any number of properties with an aggregate fair market value exceeding 200 percent of the relinquished properties. Acquire virtually all (at least 95 percent of them, based on the total fair marker value). Very few choose this option.

What else do I need to know?

In a 1031 tax-deferred exchange, you must take title to the new property in exactly the same way you held title in the relinquished property, whether it is you personally or an entity such as a trust, corporation, partnership, or LLC.

When exchanging into the replacement property, you must replace both equity and debt at the same amount or greater, if you wish to defer the capitals gains in full.

You do not have to place all of your proceeds into a new property, but whatever you take out will be taxed.

There are several other kinds of 1031 exchanges, including a reverse exchange and a construction or ‘build to suit’ exchange. The full IRS code can be found on the IRS Web site at http://www.irs.gov.

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