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What is 1031 Exchange?

The sale or exchange of business or investment property normally generates a taxable gain or loss – but under certain conditions, a taxpayer can delay the reporting of gain.  A “1031 like-kind” exchange is an exchange of property held for either investment or for productive use in a trade or business for property of like kind.

The like-kind exchange tax rules are governed by Section 1031 of the Internal Revenue Code (hence the reference to “1031” exchanges).  One investment property may be traded for another and the underlying investment amount could continue to grow, tax-deferred, for many years.

Some investors who have held a long-held investment property may have a very low tax basis in the property.  The basis may have been reduced even further by many years of depreciation deductions.  Those who would like to sell would normally be faced with significant federal and state income taxes due upon such a sale.

A properly structured 1031 exchange can solve the income tax problem by providing tax deferral for those taxpayers who want to sell their low-basis investment property but do not want to pay punitive federal and state income taxes.  The “replacement property” can take the form of another “whole” replacement property or a fractionalized property, such as a tenant-in-common (TIC) interest or a beneficial interest in a Delaware Statutory Trust.

In order to qualify for tax deferral, the following primary conditions must be met:

  • The property being exchanged, and the new property being received, must be held for rental, investment, or be used in a trade or business. The exchange does not have to be simultaneous, but the replacement property must be identified within 45 days, and actually close escrow within 180 days

  • There are three ways to identify a replacement property(s):

    • The 3-property rule to specify up to three potential replacement properties
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    • The 200% rule allows a taxpayer to specify more than three properties so long as their aggregate value is not more than 200% of the relinquished property

    • The 95% rule allows a taxpayer to specify any number of properties so long as he acquires properties before the end of the 180 period with a total fair market value equal to 95% or more of the replacement properties identified.