The Concept

Ordinarily, with the exception of a person's personal residence, when a property is sold outright, any gain is taxable. With a 1031 like-kind exchange however, the Internal Revenue Code (IRC) provides a mechanism for which the tax on gains can be deferred (not forgiven) if the property is held for investment or productive use in trade or business.

The idea is to allow a person to continue an investment in real property even if the underlying asset changes. This is commonly a solution for the owners of a "tax-locked property" where a large capital gains consequence would limit considerably the equity available to purchase a replacement property.

Considerations

The two primary goals of a 1031 exchange are deferral of capital gains taxes and preservation of equity. Accomplishing these goals can be extremely valuable when selling an appreciated business, farm, or investment real estate. Transactions of this nature should always be approached from a business standpoint. While there could be significant tax benefits to the owner that completes an exchange, there are also additional complexities and costs associated with such a transaction. The additional complexities and costs should be weighed against the potential tax implications of selling outright to determine what makes the most business and economic sense. It should also be noted that the risk of a failed exchange could result in increased tax dollars owed, loss of time, and lost opportunities.

Role of the Real Estate Professional

There are several reasons the role of a real estate professional is extremely valuable during a real property 1031 exchange:

He...
• Examines the pros and cons of a 1031 in specific situations.
• Oversees compliance with the IRC requirements on time limits, property qualifications, exchanged value rules, reporting, and documentation.
• Helps with the identification of replacement properties.
• Manages negotiations between buyers and sellers of all involved properties.
• Helps assemble a team of experts needed to successfully accomplish the exchange (CPA, attorney, tax accountant, financial advisor, lender, professional accommodator, and intermediary)
• Acts as liaison between all experts.

Eligibility

Both individuals and corporations can take advantage of this tax deferral technique. However, it is not the status of the taxpayer that determines eligibility - It's the property.

The rule requires that the property is held for investment or productive use in trade or business and that it is exchanged for like-kind property. While it is obvious that a person's primary personal residence does not meet this test, the distinction becomes less clear in certain situations.

For example, what if an owner occupies an apartment in the multi-family building he'd like to exchange? What if a tract of agriculture also includes a farm house? Most commonly, what if a resort or second-home property is owner occupied for part of the year and rented out for the rest? There are specific guidelines that address all of these scenarios.

Situations Where a 1031 Might Help Meet Objectives

Below is a list of some situations where the use of a 1031 might be beneficial:

• To diversify one large investment into several smaller ones or to consolidate multiple investments.
• As a financial strategy, a replacement property can be sought to either increase cash flow or earn appreciation depending on owner's goals.
• Often with a change of lifestyle, particularly retirement, an owner might want to reduce daily management involvement.
• When relocating, especially in retirement, owners may want to also relocate their investments.
• For estate planning, deferred tax is forgiven and heirs receive a fair market value basis (except for year 2010).
• Business change or growth  may require a different amount or type of space.
• Because the basis is carried over to the replacement property, an owner may be able to avoid negative tax consequences when the sale might trigger a recapture event.