1031 Tax Deferred Exchange Basics

If you have heard about a 1031 Tax Deferred Exchange but did not know how you might be able to implement one as a solution to your current real estate problem, then I hope I can stimulate a little thinking for you.

A properly structured 1031 exchange is the sale or transfer of property for other "like" property in a way that allows the transferee the ability to defer capital gains taxes. As a simple way of thinking about it, a property owner will trade Property A for Property B and all the existing tax basis for A will be transferred to B. During the exchange, any reduction in mortgage, any cash received, or any other benefit gained is considered "Boot" and is taxable as capital gains.

A 1031 Exchange Does Not Have To Involve A "Trade"

The first misconception that that most people perceive is that some form of "trade" needs to occur between two different parties. Actually, the concept of trade is applied in this manner. Mrs. Jones will trade her ownership in property A to ownership in Property B, therefore her capital gains implications will trade with it. She does not need to find somebody who will trade properties with her, rather she can sell Property A and then buy Property B.

Time Frames For A 1031 Tax Deferred Exchange

The process for a 1031 Tax Deferred Exchange is rather simple, though there are methods that allow for creativity that can make the exchange a bit more confusing. For the sake of simplicity though, most exchanges work like we see in the following graph:

Upon closing on the property that somebody wishes to relinquish, the exchanger has 45 days to "Identify" the replacement property (from the date of closing of the relinquished property) and 180 days to close on the replacement property (from the date of closing of the relinquished property).

Three Rules For Replacement Properties In A 1031 Tax Deferred Exchange

When conducting a 1031 exchange, the exchanger can utilize one of three rules for selecting the replacement property:

1. The 3 Property Rule - Exchanger chooses three properties and must close on at lease one of them. These three selections have no limit placed upon their combined or singular values.
2. The 200% Rule - Exchanger chooses any number of properties but does not exceed 200% of the value of the relinquished property.
3. The 95% Exception - Any number of properties can be identified but the exchanger must close on 95% of the identified properties.

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If you would like more information on 1031 Tax Deferred Exchanges, please comment below and I will continue on this with this topic.