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Tax Deferred Exchanges - The Basics

A tax deferred exchange is simply a method by which a property owner trades one property for another without having to pay federal income taxes on the transaction. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property.  But in an exchange, the tax on the transaction is deferred until some time in the future, usually when the newly acquired property is sold.

These exchanges are sometimes called “tax free exchanges,” because the exchange transaction itself is not taxed.

Tax deferred exchanges are authorized by Section 1031 of the Internal Revenue Code.  The requirements of Section 1031 must be carefully met, but when an exchange is done properly, the tax on the transaction may be deferred.

In an exchange, a property owner 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 by means of an exchange agreement and the services of a qualified intermediary—a fourth party who helps to ensure that the exchange is structured properly.

 

 

Advantages of Exchanging

The primary advantage of a tax deferred exchange is that the taxpayer may dispose of property without incurring any immediate tax liability. This allows the taxpayer to keep the “earning power” of the deferred tax dollars working for him or her in another investment.  In effect, this money can be considered an “interest free loan” from the IRS.  This “loan” can be increased through subsequent exchanges.  Moreover, under current law, this tax liability is forgiven upon the death of an individual taxpayer, which means that the taxpayer’s estate never has to repay the “loan.”  The heirs get a stepped up basis on such inherited property; that is, their basis is the fair market value of the inherited property at the time of the taxpayer’s death.

TYPES OF EXCHANGES

  • Simultaneous Exchange
  • Deferred Exchange
  • Improvement Exchange
  • Reverse Exchange

Misconceptions About Exchanging

People often fail to consider tax deferred exchanging as an investment strategy because they are misinformed about the requirements of exchanging.  However, once their misconceptions have been cleared up, property owners usually find that Section 1031 is worth considering.


Myth: Exchanges require two parties who want each other’s properties.

Fact: Two-party exchanges are possible, but in reality, such two-party swaps rarely occur. Today, an exchange is accomplished with the help of a qualified intermediary and usually involves four principal parties: the exchanger (the taxpayer), a buyer for the relinquished property, a seller of the replacement property, and the intermediary. The parties often do not know each other, and their properties may even be located in different states.

Myth: The like-kind requirements limits an exchanger’s options.

Fact: Property must be exchanged for “like-kind” property. But “like-kind” simply means that real property must be exchanged for real property. All real property is like-kind, so a whole interest may be exchanged for a tenancy-in-common interest; one property may be exchanged for multiple properties or vice versa; vacant land may be exchanged for an office building; agricultural land may be exchanged for commercial property, etc. However, real property may not be exchanged for personal property. Personal property may be exchanged for other like-kind personal property.

Myth: In an exchange, title on the exchanged properties must pass simultaneously.

Fact: The properties do not have to close at the same time. However, in a deferred exchange, the replacement property must (i) be identified in writing to the intermediary within 45 days after the closing on the relinquished property and (ii) close within 180 days after closing on the relinquished property. In a reverse exchange, the replacement property is acquired first and the relinquished property must close within 180 days thereafter.