1031 EXCHANGES

Tax-deferred exchanges, also known as , allow a taxpayer to sell a piece of property and purchase a replacement property without incurring any tax liability. By structuring the transaction according to U.S. Treasury regulations, the exchange allows a taxpayer to realize no capital gain in the sale and replacement purchase.
___ The tax-deferred exchange is a great vehicle in the situation described above — when a property owner wants to sell property in one location and buy in another. It also presents a great opportunity for a client to increase cash flow. A client with vacant land, for example, may be able to use a 1031 exchange to replace vacant land for improved income-generating rental property. The 1031 exchange allows a client to diversify or consolidate real estate investments. If, for example, your client has several rental houses and wants to exchange them for an apartment building, the 1031 could allow him to do that. Or if your client wants to sell an apartment building and buy several rental homes, the transaction could satisfy the standards of a 1031 exchange.
|___ There are two basic requirements for an exchange to qualify for 1031 status:
___ 1. The property exchanged must be of like-kind. Many people misunderstand this provision, thinking it must be a direct swap. But the requirements are a little more generous. It is possible, for example, to exchange a vacant piece of land for an improved piece and still meet the requirements for like-kind property.
___ 2. The property must be held for productive use in trade, business or investing. Examples of such property include a strip mall, warehouse, residential rental property or land held for speculative investment. This does not include personal residences; there are other provisions in the tax code that cover the taxes on the sale of a personal residence. Nor does this requirement include land that a developer holds in inventory to sell later.
___ There are three kinds of exchanges:
___ 1. Two-party exchange. Buyer and seller swap like-kind properties without being taxed for a gain or appreciation. Because it is difficult to find a buyer and seller willing to simply trade property, the tax code allows for other exchanges.
___ 2. Three-party exchange. A buyer will buy your client’s property, referred to as the relinquished property. A seller will sell the replacement property to your client by passing title through the buyer. This, too, is a rare type of 1031 exchange, because the buyer and seller often do not want to be involved in facilitating the exchange in such a way.
___ 3. Deferred exchange. This, the most common exchange, includes using an intermediary, someone who will close the sale of your client’s relinquished property to the buyer and close the purchase of the replacement property by your client. The tax code defines who can serve as an intermediary. Title insurers or bank trust departments, for example, may meet the criteria to serve as intermediaries; family members or corporations of the parties involved may not. Your client should have a lawyer or accountant assist with structuring the 1031 exchange. As a REALTOR®, your responsibility does not include advising clients on how to properly structure the exchange.
___ There are two parts to a deferred exchange transaction: Your client, the taxpayer, sells the property to the buyer under a contract between the two that is assigned to an intermediary. This sale closes just like any other real estate sale, and the intermediary holds the sale proceeds. To meet the 1031 standards to defer the tax, the taxpayer must identify a replacement property within 45 days of the sale of his own property. Within 180 days of closing the first part of the transaction, the taxpayer must close the sale on the replacement property to meet the requirements of a tax-deferred exchange.
___ To effect a 1031 deferred exchange, the contract for the sale of your client’s property should contain a clause allowing for the contract’s assignment to an intermediary. Such a clause should also require the buyer to cooperate in a 1031 exchange. Similarly, the contract for the purchase of replacement property by your client should require the seller to allow your client to assign the contract to an intermediary and to cooperate in the 1031 exchange.
___ A taxpayer who receives cash in the 1031 transaction, is relieved from debt or has a lower mortgage after the transaction is over, will realize a taxable gain to that extent. There may, however, be steps he or she can take before listing the property for sale that could decrease the potential tax liability.
___ A 1031 exchange can benefit your clients by allowing them to defer income tax, providing substantial savings. Your client’s income tax savings can be used to reinvest in higher value properties. A 1031 exchange also allows REALTORS® to represent their clients not just in a sale, but in a simultaneous sale and purchase of property that can generate two commissions. The NATIONAL ASSOCIATION OF REALTORS® offers an online, 1031 exchange course at www.realtoruniversity.com

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