TAX-FREE OR TAX-DEFERRED EXCHANGES
All real estate investors should have a sound tax strategy in place to maximize their return on investment. One such tool is the 1031 tax free or tax deferred exchange (named for section 1031 of the IRS code). In effect, the 1031 tax free exchange allows an individual to sell real property and replace it with other real property without paying any capital gains tax. Tax free exchanges may be structured in different ways, but they all need to follow specific IRS guidelines in order to be treated as such by the IRS. You need to work through a professional CPA, an exchange accommodator or facilitator, or an attorney to ensure that the structure and mechanics are strictly followed throughout the transaction.

Here is a basic overview of the process.
A 1031 tax free or tax deferred exchange occurs when you transfer a qualified property (relinquished property) and subsequently receive a qualified property as consideration (replacement property).

The property being exchanged must be “like-kind”, that is, property having the same nature or character. Like-kind does not mean exact (a rental home in exchange for another rental home). The definition of like-kind is very broad and refers to property that is used as trade, business, or investment, so you can exchange residential property for commercial, or land for residential, etc. You cannot do a 1031 exchange on your personal residence.

To qualify as a 1031, the replacement property’s value must be equal to or greater than the relinquished property.

There are two basic time limitations imposed on a 1031 tax free exchange transaction:
1)    Identification Period: All replacement property must be identified within 45 days after the sale and transfer the relinquished property.
2)    Exchange Period: The transaction must close within 180 days of the date you sold and transferred the relinquished property, or upon the filling of the taxes for the calendar year in which the relinquished property was sold.

There are limitations on the number of replacement properties that you can identify in the same tax deferred transaction:
1)    You may identify up to three properties, regardless of their fair market value.
2)    You may identify more than three properties if their combined fair market value is not greater than 2005 of the total fair market value of the relinquished property.

The investor cannot have any access, or control, over the relinquished property sales proceeds. They must be held in escrow by a neutral third party, and turned over directly to the title company handling the settlement of the replacement property.

In the event that the 1031 is successful, the tax basis of the relinquished property becomes the tax basis for the replacement property.

A 1031 tax free or tax deferred exchange is a good investment strategy for real estate investors, but one that requires strict adherence to IRS guidelines. As a result, you need to employ the services of professional exchange accommodators or facilitators to ensure that the transaction is structured properly.