The 1031 tax deferred treatment of capital gains is one of the best real estate investor vehicles for preserving and building real estate wealth: This provision of the Internal Revenue Code allows property owners to exchange their property for other like-kind property without recognition of capital gains. It makes possible to transfer the financial gain that is realized from the sale of a property into another property without federal capital gains tax at the time of the sale.

Exchanging properties is not new. The "your property" for "my property" type of direct exchange (i.e., a swap) has been in practice for a long time - it's called a two-party exchange. The difficulty is rarely will you find two owners who each want the other's property. Normally, the other owner wants to sell. This presents a problem if you want to dispose of property to finance the acquisition of new property and avoid taxable gains that would substantially reduce your equity.

The three-way or multi-party exchange was a tax-inspired technique designed to solve the dilemma of a two-way swap. However, these exchanges were fraught with danger. When one or more of the parties would not cooperate with the exchange, or one of the legs failed, the exchange failed. Multi-party exchanges, at best, were difficult and risky. And trying to sell your old property before closing on the purchase of the new property was almost impossible. This presents a problem if you desire to dispose of property to finance the acquisition of new property but want to avoid selling your property in a taxable event. A sale would produce taxable gains and could substantially reduce your after-tax proceeds. If you could exchange your property tax-free for the desired property, you could benefit from the fair market value of your property undiluted by income taxes on the sale. In other words, you can use your entire equity before taxes to purchase the Replacement Property.

To solve the dilemma, on April 25, 1991, IRS issued the long-promised deferred exchange regulation-Reg 1.1031(k)-1. It permits you to "sell" your Relinquished Property now and use the proceeds to buy the Replacement Property later. As long as it's done following the rules and using the services of a Qualified Intermediary, you get tax deferred 1031 treatment.

New Tax Terms: A deferred exchange is an exchange in which you transfer qualified property called the "Relinquished Property" and subsequently receive qualified property as consideration. The property received is called "Replacement Property".

The Deferred Exchange Regulation is a taxpayer's dream come true. It works without the buyer of your Relinquished Property or the seller of the Replacement Property getting involved in your exchange. The Reg's secret weapon was the creating of a legal entity called the Qualified Intermediary or QI. This new entity is permitted to serve as your agent and do all the exchange stuff for you without getting you involved in a taxable sale of your old property. By using a Qualified Intermediary to handle your exchange transaction, you can now turn the sale of your property, and subsequent purchase of another "like-kind" property, into a 1031 Exchange.

This regulation explaining how to put together the 1031 deferred real estate exchange is a powerful tool and strategy for selling appreciated business, farms, land, and investment real estate without recognition of gain for income tax purposes. It spells everything out, step–by–step. Just follow the rules and you can sell your appreciated property, use the cash proceeds to buy your Replacement Property and qualify for the full benefits of non-recognition of gain under 1031. The regulation has the weight of law and all parties must follow it-even the IRS.

One of the outstanding features of the deferred exchange regulation is it establishes and defines the Qualified Intermediary (QI) as your vehicle to qualify for the safe harbor procedures you must follow to get non–recognition of gain treatment on your deferred exchange.

Equity is the amount of money you have in your pocket after you have sold the property and paid off all related liabilities and mortgages. As an example, lets say you bought a property ten years ago, it's free–and–clear and has a basis of $20,000.

If you sold that property today for $115,000, and paid out $15,000 in closing costs and commissions, you have equity of $100,000. That's the amount of cash you would get out of the closing. However, your capital gain on this property would be the difference between your basis of $20,000 and your adjusted sales price of $100,000, or $80,000.

Result: If you sell instead of doing a 1031 Exchange, you would be obligated to pay a capital gains tax on the entire $80,000.

Example with Mortgage: If you had a mortgage of $90,000 on this property, you will need to repay this loan at the time of closing. This results in net cash to you at the closing of only $10,000 ($100,000 less the loan payoff of $90,000). But your capital gain tax would still be $16,000.

It is in this area you must be extremely careful not to trap yourself with a regular sale. You are almost bound to exchange in a case like this unless you have the additional funds to pay the taxes. In larger transactions with larger dollars and leveraging, the situation only gets worse.

There are three conditions that must be met to accomplish non-recognition of gain under 1031:

1. The properties exchanged must qualify, and be of "like-kind".
2. There must be an actual exchange, not a transfer of property for money only.
3. The time requirements must be strictly followed.

To meet the requirements of 1031, both Relinquished Property and Replacement Property must qualify. In other words, both the property you are selling and the property you are buying must be qualified property of like-kind. If not, your exchange will fail and be classified as a sale. This is so important it needs repeating: To qualify as a like-kind exchange, the property must be both (1) qualifying property and (2) like-kind property.

For income tax purposes, real estate is divided into four classifications. Classification is made as of the date the transaction is made. The classifications are:

Held for business use (1231)
Land held for investment (1221)
Held for personal use
Held primarily for sale (dealer property)

The first two classifications-held for business and held for investment-qualify for 1031 treatment. The second two-held for personal use and dealer property-do not.

Some properties have more than one classification at the time of sale. For example, a farmer sells his farm including his personal residence. The sale or exchange is allocated between the real estate held for personal use (the personal residence) and the real estate held for use in a trade or business (the farm). Another example is the sale or exchange of a duplex where the seller lived in one unit and rented out the other unit. The sale would be allocated.

Under 1031, both business and investment property qualify. And it does not require only business property for business property or investment property for investment property. You can mix the classifications. For example, you can exchange an apartment house (business property) for two unimproved lots (investment property). Or a commercial warehouse (business property) for a 60-acre tract of raw land. All could qualify.

This information provided is only an introduction to 1031 Tax exchanges but you must consult with a professional before making any decisions.

DO --- Advanced planning for the exchange. Talk to your accountant, attorney, broker, lender and Qualified Intermediary.
DO NOT --- Miss your identification and exchange deadlines. Failure to identify within the 45 day identification period or failure to acquire replacement property within the 180 day exchange period will disqualify the entire exchange. Reputable Qualified Intermediaries will not act on backdated or late identifications.
DO --- keep in mind these three basic rules to qualify for complete tax deferral:
1. Use all proceeds from the relinquished property for purchasing the replacement property.
2. Make sure the debt on the replacement property is equal to or greater than the debt on the relinquished property. (Exception: A reduction in debt can be offset with additional cash; however, a reduction in equity cannot be offset by increasing debt.)
3. Receive only "like-kind" replacement property.

DO NOT --- Plan to sell and invest the proceeds in property you already own. Funds applied toward property already owned would not qualify as "like–kind" property.
DO --- Attempt to sell before you purchase. Occasionally Exchangers find the ideal replacement property before a buyer is found for the relinquished property. If this situation occurs, a reverse exchange (buying before selling) may be necessary. While the IRS has recently provided guidance for reverse exchanges in Revenue Procedure 2000-37, Exchangers should be aware that reverse exchanges are considered a more aggressive exchange variation because some other entity must hold title to either the Exchanger´s relinquished or replacement property for up to 180 days pending the completion of the exchange transaction.
DO NOT --- Dissolve partnerships or change the manner of holding title during the exchange. A change in the Exchanger´s legal relationship with the property may jeopardize the exchange.