For Seller - IRC Code 1031 Exchanges
       
             Section 1031 Exchange Can Reap Big Tax Savings
                                      The IRS's Regulations Make Exchanging
                               Easy, Inexpensive, and Safe!

Normally, sellers of real estate are liable for taxes on the gain recognized (profit) on the sale. This is true for principal residences, vacation homes, investment properties, etc. Congress, however, permits taxpayers to defer that tax to a later date in some cases.
 
"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."
 
The general rule is that if property is sold in a typical sale transaction, gain or loss may be recognized. This gain is recognized as a 'capital gain' and subject to both Federal and State capital gains taxes.
 
IRS Section 1031 basically provides an exception to the general rule by providing that gain or loss will not be recognized on the exchange of business or investment property, if it is exchanged for "like kind" property. The gain is not forgiven, but is simply rolled into the new property and may be recognized later when a typical sale takes place.
 
"Like kind" property refers to the nature, character or class of the property, not to its grade or quality. This definition includes an exchange of real estate for other real estate. As long as both parcels are in the U.S., the specific location of the property does not matter.
 
How an Exchange Works
 
Two property owners rarely want each other's properties. In reality, most exchanges involve four parties: 1) the taxpayer who wants to dispose of his property but delay taxation (the Exchanger), 2) the buyer for that property, 3) a seller who has property that the taxpayer (Exchanger) wants to acquire and 4) a qualified intermediary, who helps to ensure that the exchange is structured properly..
 
If the taxpayer sells his property, then re-invests the proceeds into a new property, he will have to pay taxes on the gain on selling his property and will not have the full value to invest. By exchanging, he is dealing with the full property value and not one reduced by taxes.
 
In an exchange, a property owner simply disposes of one property and acquires another property.  The transaction must be structured in such a way that it is, in fact, an exchange of one  property for another, rather than the taxable sale of one property and the purchase of another.
 
Today, a sale and a reinvestment in a replacement property are converted into an Exchange Agreement and the services of a Qualified Intermediary - a fourth party who helps to ensure that the exchange is structured properly.

The IRS's regulations make exchanging easy, inexpensive, and safe.

General Rules
 
In order to defer the capital gains taxes on the sale of real estate, the property owner [taxpayer] must exchange the property for a 'like-kind' property. This is accomplished by selling the owners property, placing all the monies received from the property sale in the Qualified Intermediary's escrow account and then using the proceeds from this escrow account to purchase the new [replacement] property.
 
The taxpayer can not receive or take any of the 'cash' from the sale, but must deposit all the proceeds with an intermediary party, such as a title company or other recognized intermediaries, otherwise, the exchange will fail for purposes of deferring capital gains taxes.
  
Deferred Exchanges
    
Once the original property that is being sold [relinquished property], sells and the proceeds are placed in escrow, the taxpayer has 45 days from the close of relinquished property (escrow) to identify up to three distinct properties that they wish to purchase. Once these properties are identified, the taxpayer then has 180 days from the closing of the relinquished property in which to make the final purchase of one or more of these three identified properties.
 
New Construction
   
The IRS regulations provide special rules for identification and receipt of replacement property to be produced and state that the deferred exchange will not fail merely because the replacement property is not in existence or is being produced at the time it is identified as replacement property. The regulations, in a nutshell, require the taxpayer to identify the land and improvements in as much detail as is possible at the time and, if the property is not complete when acquired, then the taxpayer is credited with receiving the land and whatever percentage of the building is complete, as far as the property qualifying as like-kind is concerned.
 
Reverse Exchanges [Starker Exchanges] 
   
In reality, it is often difficult to find and identify replacement property within the 45 days allowed by the IRS under section 1031. Often taxpayers will find the replacement property first and then place their original property up for sale. This is known as a "reverse exchange." Effective for exchanges commenced on or after September 2000, Revenue Procedure 2000-37 provides rules and procedures that, if followed, will not cause the IRS to disallow such exchanges if they are otherwise valid.
 
Qualified Intermediaries or Safe Harbors
   
The IRS has identified specific rules for companies that are 'qualified intermediaries'. These can be title companies, lawyers or other agents capable of holding an escrow account for the taxpayers. Essentially, these intermediaries 'hold' your proceeds [cash] from the sale of your original, relinquished property. You will not be permitted any access to these funds, without voiding the 1031 transaction.
  
Once the relinquished property is sold and the escrow closes, the taxpayer and the exchange accommodation titleholder [escrow account holder or title company, etc.] enter into a written agreement (the "qualified exchange accommodation agreement"). This agreement provides that the exchange accommodation titleholder [EAT] is holding the property for the benefit of the taxpayer in order to facilitate an exchange under section 1031.
 
Additionally, no later than 45 days after the transfer of ownership to the exchange accommodation titleholder, up to three properties that meet the "like-kind" criteria must be identified for purchase with the 'parked' monies.
 
Then, no later than 180 days after the transfer of ownership of the relinquished property to the exchange accommodation titleholder, the replacement property must be purchased and will be transferred through the qualified intermediary to the taxpayer.
  
In summary, the IRS has provided very specific rules for handling a capital gains tax deferred property sale and the purchase of a replacement property. The capital gains taxes are thus not 'recognized' on the exchange, but are deferred until the subsequent sale of the replacement property. In the event of another exchange of the replacement property in the future, then the capital gains taxes are continually tax deferred, until a taxable event [a sale] actually occurs.
 
Sources of information about these IRS Section 1031 provisions can be found in IRS Publication 544 [Sales and Other Dispositions of Assets] and on the internet at http://www.irs.gov.

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