A tax-deferred or 1031 exchange is a transaction involving the transfer of investment or income property and the receipt of like-kind property which will be used as income or investment property. When certain criteria are met, as set forth in Section 1031 of the Internal Revenue code, the income taxes on any gain realized from the sale of the relinquished property are deferred.

Why Do Investors Exchange? Exchanging As A Solution...

Avoidance of Tax Liability at the time of Property Disposition... while at the same time:

• Consolidation of investments by exchanging several properties into one
• Diversification of investments by exchanging one property into several
• Cash flow considerations (i.e. exchange of land for income producing property
• Relocation of a business through an exchange
• Increased investment leverage (the trading of high equity property for other property with a higher debt-income ratio)
• Elimination of co-ownership problems
• Exchanging from management into an equity share or triple net lease property with little or no management

Investors can generally expect to pay 15-20% of their capital gain in federal taxes after selling investment property, plus any applicable state taxes. This liability can be substantial, depending on the particulars of the transaction. Alternately, a qualified exchange will allow investors seeking additional investment opportunities the ability to transfer assets without paying a significant percentage of the sale proceeds to the government. If an investor's goal is to acquire other investment property, then exchanging is an investment strategy worth serious consideration.

Sample Capital Gain Calculations

For example, Investor A is evaluating whether or not to exchange a rental property. The sales price is $370,000, sale expenses are $20,000, the existing mortgage is $170,000 and the taxpayer's adjusted basis (original purchase price less depreciation plus improvements) is $150,000. The sale would result in a capital gain of $200,000.

Basic Computation	Gain Computation
Original Purchase Price:       $ 200,000	Sales Price:                     $ 370,000
Capital Improvement:          +  25,000	Less Expense of sales: (-)  $   20,000
Accumulated Depreciation:   -  75,000	Net Sales Price:                $ 350,000
	Less Adjusted Basis:    (-)  $ 150,000
Adjusted Basis:                  $ 150,000
	Gain:                              $ 200,000
Equity Computation
Net Sales Price:                 $ 350,000
Less Mortgages:                 - 170,000
Equity:                             $ 180,000

Analysis: In the above example, should investor A decide not to exchange, the taxable gain will be $200,000. This equates to federal income tax liability of $37,500, excluding any state tax liability. By acquiring replacement property equal or greater in value than that of the relinquished property and using all of the equity of $180,000, the entire gain will be deferred and no income taxes will be due.

THUS, AN INVESTOR CAN DEFER 100% OF THE TAXES THROUGH 1031!

The Power of Leverage

What Happened?

Each put down the same amount for the same amount of time. Each investment doubled in value during the investment period. So why did Investor A make 5 times as much on her investment as Investor B Made on hers? The difference illustrates perfectly the power of leverage. While they were each making the same on their initial investments, Investor B was also making the same amount on the 80% borrowed. The bank just wants interest. Capital gains made on the banks investment goes to the investor, not the bank.

Section 1031 Ties Nicely Into Leverage Calculations As The Tax Deferred On The Transaction Can Provided Further Leverage!

1031 Basic Rules

• Both relinquished and replacement property must be "held for productive use in a trade or business or held for investment" and property must be "like-kind." All real property is like-kind.

• The purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property.

• All cash or other proceeds received from the sale of the relinquished property must be used to acquire the replacement property.

Exchange Timelines

The investor has 180 days to complete their exchange after the transfer of the relinquished property, or the due date of their tax return for the year in which they relinquish their property (unless an extension is filed) whichever occurs first. By the 45th day, replacement property must be identified in a manner consistent with the IRS regulations.

	Total Exchange Period
	0	45 Days	180 Days
	Relinquished	Identification	Target Property
	Property	Letter Due	Transferred
	Transferred		Exchange Complete

Know Your Exchange Types...

Simultaneous

A simultaneous exchange occurs when ownership of both the relinquished property and the replacement property transfers concurrently. Simultaneous exchanges are are due to difficulties in coordinating concurrent deed transfers on multiple properties.

Delayed

The delayed or "starker" exchange is the most common type of exchange. In a delayed exchange, the relinquished property is transferred at Time 1, and the replacement property is acquired at Time 2. There are variations to the basic delayed exchange.

Reverse

Example 1:

Investor wishes to acquire title to the replacement property before the relinquished property sells. The intermediary, acting as an Accommodating Titleholder (AT), acquires the replacement property and warehouses it until the relinquished property sells, at which time a simultaneous or delayed exchange is structured.

Example 2:

Intermediary becomes an interim or "straw" buyer for the relinquished property and immediately structures a simultaneous exchange into the replacement property.

Improvement/Construction

New construction or improvements can be added as part of the exchange with title passing to the intermediary who in turn makes payments to contractors and other suppliers out of the exchange funds. Title is then transferred to the exchangor at the higher value upon completion of improvements or the 180th day, whichever occurs first.

In essence, if replacement property is of lesser value than the relinquished property, improvement or construction is an effective tool to increase the value of the replacement property to reduce or eliminate a taxable event.

Business/Personal Property

Internal Revenue Code Section 1031 permits the exchange of property other than real estate. For example, investors may exchange business assets, valuable paintings, livestock, equipment or other personal property. Although business or personal property exchanges are common, they can be trickier because they require very specific asset allocations. Also, like-kind definitions are more restrictive than with real property. For these reasons, an exchangor should consult a tax advisor before initiating an exchange and should carefully select the intermediary.

For more & updated information, please contact your CPA or tax attorney.