INVESTOR  INFORMATION

What is a 1031 Exchange?

 The Internal Revenue Code, Section 1031, is the section that allows for the deferral of gain where a transfer of properties occurs at different times.  The properties must be used in a trade or business or as investment properties.   In other words, if you sell a piece of property that is not a personal residence, then reinvest the money within the 180-day replacement period in another piece of qualifying property (not your personal residence), then there may be little or no tax due at that time.

These provisions in the law have been around in various forms nearly as long as the income tax itself.  They are not tax “loopholes” but rather a method of deferring taxes when a taxpayer does not receive any cash equity or debt relief.  You are still in control of your real estate dealings, but for very little effort or cost, you can take advantage of one of the last real estate tax shelters available by using a "Qualified Intermediary."

Why is it important for the Investor to know about exchanges?

 1.           Tax Savings

If your property has increased in value, or if you have depreciated it over a number of years, your tax basis (your “cost basis”) probably is much less than the property's fair market value.  If you were to sell the property, you would have a taxable gain based on that difference.  Federal capital gain rates are now 15 percent.  You must factor in your state rate as well as most states also taxes these gains. For depreciable real property there may be a recapture the depreciation you have taken over the years.  This is called “Section 1250 recapture” and that rate is 25. The combination of these various rates will tell you about how much tax you will have to pay in a standard property sale. 

If you reinvest the sales proceeds into another property, however, the taxes on the gain may be deferred.  Taxes will not be payable if an exchange is done properly.  This method is completely legal, and in fact, was carved out in its present form by the Internal Revenue Service in 1991.  The reason there is no tax due rests on a long-standing principle in tax law which states that taxes are not due where no sale occurs, or where no cash is received.   

2.           Ease of Use

A tax-deferred exchange will "feel" very much like an ordinary property sale.  There will be some additional steps that must be followed, but they will be handled by the Qualified Intermediary.  For the most part, it will be as if you sold one property and bought another.  If the two transactions are handled correctly, you can defer your taxes otherwise due.  Most investors find this a painless process, because the work is handled primarily by professionals -- the Intermediary and your tax preparer, CPA or attorney.

Defining some terms with which you will become familiar.

1.           "Like-Kind" -- Like-Kind Real Property is simply other Real Estate interest which are for investment or use in a trade or business.  IRS regulations issued in 1991 greatly simplified what had been a source of uncertainty in the law.  There are many facets of "like-kind" property, but for Investors, it is a valid principle that ANY INVESTMENT OR BUSINESS REAL PROPERTY MAY BE EXCHANGED FOR ANY OTHER TYPE OF REAL PROPERTY THAT IS FOR INVESTMENT OR USE IN A TRADE OR BUSINESS. 

 

2.           "Investment Property" or "Property used in a Trade or Business" -- The properties involved in the 1031 Exchange must be Investment or Property used in a Trade or Business.  Generally, if you hold property purely for investment or are renting the property, then it qualifies.  These provisions DO NOT apply to your personal residence.  Raw land may be traded for an apartment house.  A residential rental may be traded for raw land or for a commercial building.  Your professional advisors will deal with the question of whether the property is an Investment Property or a Property used in a Trade or Business. 

3.           Accommodator -- an unrelated third party who holds funds and purchases replacement properties on behalf of an Exchangor.  Also called a Qualified Intermediary or Facilitator.  It is used interchangeably throughout this document.

 

4.           Exchangor -- This is you as the Seller, and is often referred to as the Taxpayer.

 

5.     Relinquished Property -- This is the property that you are transferring and wish to dispose of.

 

6.           Replacement Property -- This is the property that you end up with at the end of the transaction.

7. Boot -- In an exchange of real estate, the "boot" is any asset received other than the  replacement property.  There are different types of "boot."  For instance, if you receive the replacement property plus $100,000 in cash, the cash is the "boot." Mortgage boot is based upon the difference in liability between the two properties involved.

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