1031 Exchanges

In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain.

The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

  • Rule 1: The replacement property must have an equal or greater acquisition cost than the adjusted sale price for the relinquished property.
  • Rule 2: The exchanger may not receive cash - all the proceeds in the qualified escrow account must be reinvested.
  • Rule 3: The new or assumed mortgage total should be equal to or greater than the debt paid off on the relinquished property, or the exchanger must add new cash to offset the difference.
  • Rule 4: Taxpayer may not receive non-like property -- including owner held notes, cash or personal property.

Although not required by 1031 exchanges- a buyer would think about “exchanging up” into a higher priced investment. The IRS only requires that you are equal OR greater then your exchange-out property. (All proceeds from a sale are recognized.)

In other words, the fair market value of the replacement property must be equal or greater than the fair market value of the relinquished property. Second, the equity in the replacement property needs to be equal or greater than the equity in the relinquished property. Finally, the mortgage on the replacement property needs to be equal or greater than the mortgage on the relinquished property. If you have a trade down in any of these areas you will be taxed on the value of the trade down