1031 exchanges allow flexibility, defer taxes

By following some very specific rules set forth by the Internal Revenue Service, your client can choose to participate in a Section 1031 exchange and defer payments of federal income taxes on the gains.
OCT 07, 2008
By  Bloomberg
Situation: Your client holds several rental properties for investment purposes but is interested in selling one of them to buy a larger property. He has had the original property for five years. He expects to sell it at a significant profit and wants to know what to do to defer his current tax obligation. Solution: By following some very specific rules set forth by the Internal Revenue Service, your client can choose to participate in a Section 1031 exchange and defer payments of federal income taxes on the gains. That section of the Internal Revenue Code states that gain or loss won’t be recognized on the exchange of property held for investment, or other types of trade or business. Basically, when funds are immediately reinvested in another property, no economic gain is realized, which would generate tax. While a 1031 exchange may seem complicated, it should be considered in your client’s situation because it is one of the few options available to defer taxes on the sale of an investment property. This will give your client the ability to modify his investment portfolio as market changes affect which type of properties will be profitable, without having to pay taxes associated with gains. The taxpayer’s investment is still the same, but the investment is now in another form (a house exchanged for an apartment building, a warehouse exchanged for a shopping center, etc.). There are several different types of exchanges, and your client will need to decide which one best suits his or her needs before beginning any transaction. Any sale that will claim a 1031 exchange must have the stipulation in the escrow paperwork at the time of sale — the provision cannot be added retroactively. The taxpayer has only 45 days in which to identify a replacement property and 180 days in which to complete the exchange. If this period of time extends past the due date of the taxpayer’s federal-tax-return filing, he or she should ask for an extension in order to receive the full 180 days in which to complete the transaction. An immediate 1031 exchange is where the properties involved are exchanged at the same time. While there is the possibility for a delayed exchange, the time limits imposed by the IRS are very strict and still require an initial intent to follow 1031 exchange guidelines. In addition, a reverse exchange is also possible when the replacement property has been acquired prior to the sale of the original property. In order for a valid 1031 exchange to take place, the properties must be “exchanged” rather than selling one property and using the proceeds to buy another property. Your client is not allowed to have access to the proceeds at any time during the transaction. Any money received is considered “boot” and is subject to current taxation. One way to resolve this issue is to use a qualified intermediary to “park” the money. There are several companies that provide this service and facilitate meeting the proper requirements for a 1031 exchange. Your client will also have to be sure his or her property qualifies under the stipulations set forth by the IRS. For example, personal residences and properties acquired for immediate resale will not qualify. In addition, other types of property are specifically excluded from Section 1031 exchanges. The IRC should be consulted.
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