What is a 1031 Exchange?

Go Gated Realty® works with many Hilton Head buyers and sellers who benefit from the use of 1031 exchanges.  These exchanges are not complicated but they do have specific rules, require planning and the participation of a certified intermediary like WaMu Exchange (Washington Mutual) a national leader in 1031 exchanges.  I have found The WaMu staff to be exceptionally courteous and generous with their time and advice and I  recommend them to anyone interested in 1031 exchanges.  They can be reached by telephone toll-free at 1-800-966-1031 or by e-mail at This e-mail address is being protected from spambots. You need JavaScript enabled to view it

The following information is presented with their permission from their website http://www.wamu1031x.com/

Normally when you sell property, you must recognize gain or loss in that transaction.
If it is a gain, it is subject to tax (Federal capital gains tax, potential state income tax and potential depreciation recapture taxes).

Section §1031 of the Internal Revenue Code (IRC), however, provides an exception to that general rule.

IRC §1031 states that:
"No gain . . . shall be recognized on the exchange of property held for productive use in trade or business or for investment if such property is exchanged solely for property of like kind . .” 

The concept is simple:

In a 1031 exchange, you exchange Property A for Property B.
The sale proceeds from A are used to pay for the purchase of B.
By using a "Qualified Intermediary" (also called "Accommodator") to transfer both properties and funds, rather than you doing so directly, your tax liability is deferred.

Benefits

1. Instead of selling a property, paying taxes on it, and then using the reduced after-tax proceeds to buy other real estate, IRC §1031 allows you to defer the capital gains tax owed. This enables full reinvestment of your sale proceeds. The amount not paid in capital gains tax to federal and state governments creates increased equity in your investment.
    
2. Tax deferment increases the availability of your money which can be invested into better property(s) of greater value. Tax deferment is leverage, and leverage creates wealth. In effect, you receive an interest-free loan from the government, in the amount you would have paid in taxes.

Basic Requirements for a Successful Exchange... IRC §1031 states that:
 "No gain … 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 …".

To qualify, the following requirements must be met:

1. There must be at least two properties in an exchange:
   One (or more) that you are selling, and one (or more) that you are replacing it with.
    
2. The properties being exchanged must "qualify":
   They must be held for use in trade or business (e.g., office building, warehouse, industrial space, farmland, retail building) or for investment (e.g., raw land, rental home/apartment/condo). The properties that you are exchanging do not have to be identical. All of the above examples are "like kind" in nature, so you can exchange land for warehouse, office for rental home, etc.
   Property that you own for personal use (e.g., your primary residence or a vacation home) does not qualify for a 1031 exchange.
    
3. To defer ALL of your capital gains:
   The purchase price of your replacement property(s) must be equal to or greater than the sales price of your relinquished (sold) property(s).
   
   All of your sale equity (cash) must be reinvested in the replacement property(s).
      
4. You MUST use a "Qualified Intermediary" (Accommodator).
    The IRS will not allow you to receive cash proceeds or take "constructive receipt" of the funds in any way, or else you will be taxed.
    
   It is the accommodator who legally sells Property A to buy replacement Property B on behalf of the taxpayer, creating an exchange of properties. The client has the freedom to identify what he wants to sell and what he wants to replace it with, but the accommodator is the legal vehicle through which the properties are transferred.
    
   The accommodator guides the 1031 process and provides appropriate documentation that enables qualification. Most importantly, the accommodator must be totally independent: it cannot provide tax, legal, or financial advice to you.   
    

5. Timing rules must be met. Failure to meet any of these deadlines will disqualify the exchange:
   
   Prior to closing on the relinquished property: demonstrate intent to perform an exchange via a written agreement with the accommodator. 
   
   Within 45 days from the closing date on the relinquished property: identify one or more potential replacement properties.
   
   Within 180 days from the closing date on the relinquished property: acquire one or more of the replacement properties which have been identified.

The Exchange Process: A Simple Example

Mary wants to sell her land in Texas to Mr. Smith for $200,000 and use the sale proceeds to buy a $300,000 rental condo in Florida from Mrs. Jones. If she simply sold the land to buy the condo, she would pay capital gains tax on the land (which would leave her less money in hand to buy the condo). However, if the transaction is structured as a 1031 exchange, she defers paying that tax.

The 1031 process works like this:

1. Prior to closing on the land sale, Mary provides TIMCOR (usually through her escrow, title company, or closing attorney) with information about her pending sale. She then signs an exchange agreement prepared by TIMCOR indicating that she intends to do an exchange, and that TIMCOR assumes the role of seller on the land.

2. At the moment she closes on the sale, Mary's land is deeded directly to Mr. Smith. He, in turn, pays money for the land, and the money goes to and is held by TIMCOR.

3. From the closing date, Mary has 45 days to identify replacement property(s) for her land, and 180 days to close on it.

4. Prior to closing on the replacement rental condo, Mary again contacts TIMCOR. An additional agreement is prepared for her signature, specifying that TIMCOR assumes the role of buyer for the condo.

5. When the condo closes, the condo is deeded directly to Mary. Mrs. Jones is paid the funds TIMCOR is holding from the sale of Mary's land, plus additional funds from Mary, or her lender, since there is more owing on the more expensive condo.

6. In summary, Mary exchanged her land for a condo. The proceeds from the sale of land went to pay for the condo without ever touching Mary's hands.