Section 1031: What is a Tax-Deferred Exchange?

There are many ways to accumulate wealth, even in periods of economic sluggishness. One of the more attractive investment vehicles is an investment in real estate. Careful consideration should always be given to selecting appropriate investment properties, such as apartments, commercial properties, vacant land, or other types of investment properties. Likewise, the same consideration should be given when disposing of one property and reinvesting in another. Unfortunately, many investors fail to even consider one of the most tax efficient methods “investing up” in more valuable real estate — the tax deferred exchange.

Say you have owned a small investment property for a number of years. The property has appreciated in value, and depreciation deductions have reduced your cost basis to a level where selling the property carries a relatively high tax cost. If you wanted to use the equity in this property to purchase a larger, more attractive property, you could either (i) refinance the property (assuming you could obtain financing); or (ii) sell the property and invest the proceeds in the new property. Note that if you sell the property, you cannot defer tax on the gain merely by buying another investment property. However, you can defer the tax if you structure the deal as a “like-kind” exchange rather than a sale. This will enable you to apply all of the appreciation in your property, undiminished by the tax that would otherwise be payable, towards acquiring replacement property.

To qualify for like-kind treatment, four conditions must be met:

  1. There must be an exchange, rather than a sale, of properties.
  2. You must hold both the property traded and the property acquired (referred to as the “replacement property”) for business or investment purposes.
  3. The properties must be of like-kind, e.g., in our example, if you dispose of a parcel of real property, you must receive real estate in exchange. Note that improved real estate may be traded for vacant land, and vice versa, and still qualify as “like-kind” property.
  4. The properties must not be certain excluded types of property. For example, stocks, bonds, notes, securities, evidences of debt, or partnership interests may not be exchanged in a “like-kind” exchange transaction. In addition, the property traded and the property received must not be held primarily for sale, such as inventory.

The most common types of exchanges are “simultaneous” exchanges, and “deferred” exchanges. A simultaneous exchange is one in which you trade your property for property that another party already owns, i.e., the transfers occur contemporaneously. A deferred exchange is one in which you transfer property for the other partys promise to acquire and transfer property of like kind to you. Deferred exchanges must satisfy two timing rules. First, within 45 days of the date you sell or transfer your property, you must give the other party written identification of the property you want to receive. Second, you must receive that property by the earlier of 180 days after you transfer your property or the due date of your tax return for the year of your transfer.

As a practical matter, our firm recommends that our clients engage the services of a qualified intermediary to handle a deferred exchange. This eliminates the need for the purchaser of your property to participate in the completion of the deferred exchange. As further security, we also recommend depositing your purchaser’s funds in escrow. These accounts may be set up as escrows or trusts. Both the exchange agreement with the intermediary and any escrow or trust agreement must expressly limit your right to receive, pledge, borrow or otherwise obtain the benefits of the cash or cash equivalent received from the purchaser before the end of the exchange period. Also, neither the intermediary nor the escrow holder or trustee may be a “disqualified” person (such as your agent) or someone who is “related” to you or your agent. Thus, neither our firm nor any of our attorneys could serve as an intermediary or an escrow agent for one of our own clients.

Here are some special rules to note about like-kind exchanges:

  • The tax consequences to the other party do not affect your tax status.
  • If the properties are not equal in value, one party can transfer cash or other nonlike- kind property (referred to as “boot”) to equalize the values exchanged. Although the boot is taxable to the recipient, the transaction will usually still qualify for the favorable tax treatment.
  • If you transfer a liability in the exchange, the liability is treated as “boot” and thus the amount of the liability you transfer will be taxable to you.

Structuring a like-kind exchange can be complex, but the tax deferral is often worthwhile. If you want to discuss the merits of pursuing a likekind exchange instead of sale in your investment management, please call one of the attorneys in our Tax Department to arrange a consultation to discuss your options.