Tax free exchanges of “property”

written by OSblueprint
9 · 12 · 22


The Internal Revenue Code allows you to defer gain on real estate and other property used for investment purposes by exchanging that property for other “like kind” property, thereby building your portfolio while deferring any tax. You can retain the taxes then deferred and use them for further investments. In other words, you can use the full equity in the first property without a reduction for tax payment to leverage the acquisition of more expensive replacement property. It also allows you to get rid of unproductive property (low income producing, vacant land, etc.) and exchange it for more productive property without the immediate tax burden.

This procedure is often called a “Starker Exchange” but is more commonly called a “1031 Exchange,” after Internal Revenue Code Section 1031 which states:

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such
property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

By definition, the property usually excludes your residence.

While both real property and certain types of personal property interests can be used under this tax section, real estate investments are the least restrictive. This memo is restricted to discussion of the exchange of real property. In that category, “like kind” really means any real estate in the United States (or leasehold interest greater than 30 years) regardless of the difference in type or quality of real estate.

While the Internal Revenue Code section grants some significant benefits, it comes with rather severe restrictions in the nature of time limitations and procedure requirements. These are:

  1. The property being acquired ( “replacement property”) must be properly identified within 45 days after closing on the property you are transferring (“relinquished property”).

Practice note: “Identified” is covered by a letter specifying the property to be acquired later. Usually even before the closing on the first property, the taxpayer already has a good idea of what property he wants to obtain in exchange and as a safeguard will identify several
properties at the same time. Up to three properties may be “identified” regardless of market value in relation to the first property. If more than three, there are specific rules limiting value.

  1. You must close on the “replacement property” within 180 calendar days of the closing date on the “relinquished property.” This 180 days is shortened by the due date of your tax return for the year in which you transfer the relinquished property. (If you close on the old property December 31st, since your tax return for that year is due by the following April 15th, you have only 105 days to close on the new property.) There are no extensions allowed for this time limit.
    .Practice note: Close on the first property at least before mid-October to take advantage of the full 180 days. You must not have either actual or constructive receipt of the proceeds from the first property. To facilitate this rule, the IRS regulations established use of a “qualified intermediary” or escrow agent to facilitate the entire transaction. This is set up by a written agreement between you and the qualified intermediary, by which the intermediary acquires the first property from you and transfers it to the purchaser. When the replacement property is identified, the intermediary then acquires the replacement property by assignment and then transfers that property to you to complete the exchange.
    Practice note: To be qualified as an intermediary, that person must be relatively independent. Typically the IRS considers your own attorney as “disqualified” so you should expect your own attorney to recommend or use another professional as the intermediary escrow agent.

Use of this Web Site and review of this Article does not create an attorney- client relationship. The law and its application by the courts is constantly evolving and changing. As with all memoranda in these archives, the discussion of the law is for general informational purposes, is in general summary form, is not to be taken as a definitive guide, and should not be relied upon to determine all fact situations. Each set of facts must be examined separately with the current case and statutory law analyzed and applied accordingly.




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