last update 12-10-02

IRS Section 1031 Tax Free Exchanges

The Internal Revenue Code 1031 provides investors with one of the last available tax shelters by allowing them to avoid paying any taxes when an investment property is exchanged. Why, when and how this happens are questions that should be answered here.

The general rule is that if property is sold in a typical sale transaction, gain or loss may be recognized. However, 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. The non-recognition in an exchange is not elected it is mandatory if the conditions are met.

"Like kind" property refers to the nature, character or class of the property, not to its grade or quality. This definition would include 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.

The non-recognition provisions do not apply to stock in trade (inventory), stocks, bonds and notes, interests in partnerships, or other securities.

How an Exchange Works

Two property owners rarely want each other's properties. In reality, most exchanges involve three parties: the taxpayer who wants to dispose of his property but delay taxation, the buyer for that property and a seller who has property that the taxpayer wants to acquire. If the taxpayer sells his property, then re-invests the proceeds into the 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 concept, the buyer purchases the property that the seller wants to acquire and then the buyer exchanges it with the seller. The seller disposes of his property and gets a replacement property without paying taxes, the buyer parted with his money and got the property that he wanted and the third party simply sold his property. In reality, all three parties normally have a closing on the same day in which they come in with the properties that they have and leave with the properties or cash that they want.

With careful planning and a sharp eye toward timing, the above transaction can be expanded somewhat. The above example assumes that the 3 parties can come to the same closing table to conclude the transaction. However, the taxpayer can defer the selection of his new acquisition for 45 days and the actual taking of it for 180 days if he is careful. Thus, if Taxpayer has a potential buyer ready to deal today but Taxpayer has not yet found the property that he wants to acquire in the exchange, he can proceed with a transfer of his own property to Buyer and have the proceeds placed in an escrow account. He must then select the property that he wants to acquire within 45 days and must actually take title within 180 days of the disposition of his own property. This delayed exchange can be tricky and should not be undertaken without professional advice for the specific facts involved.

Caveat: Be sure that all the requirements are met. 

	In a Tax Court case, a couple did everything for a
	deferred exchange but the seller backed out of the deal the
	day that it was set for closing.  The taxpayer still claimed
	tax free status on the transaction and argued that he had
	done everything that he was supposed to do and that the
	seller's change of heart was outside his control.  The Tax
	Court said that the Internal Revenue Code creates no
	exceptions to the deadline, so the taxpayer cannot treat it
	as a valid tax free exchange.   David A Knight, TC Memo
	1998-107

What Is Like-kind Property
Like-kind property refers to the nature, character, or class of the property, not to its grade or quality. Thus an exchange of real estate for real estate is a like-kind exchange. It doesn't matter where the property is located or whether it is improved or unimproved. This means not only exchanging an apartment building for an apartment building but also exchanging an apartment building for a farm, vacant land, a cranberry bog or any other real property, as long as the new property is not the investor's personal residence. The requirement in the statute that the exchange is only available for "business or investment property" eliminates an exchange of the Taxpayer's residence under this section. Further, he must intend to keep the newly acquired property for at least six months and preferably a year. To sell it sooner may classify the Taxpayer as a dealer since these provisions only apply to exchanges of property for productive use in a trade or business or for investment purposes.

"Boot" or Liabilities in Exchanges

If a Taxpayer receives boot (money or other non-exchangeable property) in the exchange transaction, gain will be recognized to the extent of the boot received prior to recognizing the tax deferral provisions of the exchange. Thus, gain will be recognized and taxes will be paid on the cash received. To avoid this problem, make the exchange so that cash is not received. Liabilities transferred to the Buyer will be treated as boot received.

If boot is given in the exchange, the amount of the boot simply increases the Taxpayer's basis or cost in the property acquired. Liabilities assumed will be treated as boot paid. However, liabilities transferred will be netted against liabilities assumed to determine the net amount of any boot.

Basis in Exchanges

In tax parlance, basis refers to the net, adjusted cost of a property. In real estate, it is common to depreciate the improvements in a property over its useful life. Thus, a parcel that costs $60,000 may be depreciated down to a current tax basis of $50,000. However, the actual property could have gone up in value to $200,000 due to location, inflation, etc. The Taxpayer will be exchanging his property for other property worth $200,000. In acquiring the new property, his old net depreciated basis of $50,000 would be transferred to the new property. In essence, the basis for the old property simply becomes the basis for the new property. Thus, if he later sold the new property, he would have a gain on the difference between the sales price of the new property and the $50,000 carryover basis. Future depreciation on the new property would be limited to the basis figure of $50,000 also.

Exchanges with Related Parties

If an exchange occurs between related parties, and if either party disposes of the exchanged property within two years of the last transfer of the exchange, then gain or loss not recognized in the exchange will be recognized and taxed. The term related parties included a Taxpayer's family, brothers, sisters, ancestors, lineal descendants and corporations with more than 50% controlled by related parties.


========================  WARNING  =======================
                      AND DISCLAIMER
This information is provided for the reader's benefit in
becoming familiar with the legal matters discussed.  Your
particular facts may be different from the points above.
You should not rely on the above data without consulting a 
attorney to discuss the specific facts of your case
and the law of your state.
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last update 12-10-02

IRS Section 1031 Tax Free Exchanges

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