Our previous newsletter was about house exchange as an alternative to buying and selling your personal residence or main home.

You may have heard of such exchanges under different names, including: 1031 exchange, Starker exchange, tax-free exchange, tax-deferred exchange, trading properties, delayed exchange, like-kind exchange, etc...

Whenever you sell business or investment property and have a gain, you generally have to pay tax on the gain at the time of sale.

The IRS depreciates capital real estate investments at a 3% per year rate as long as you hold the investment, until it is fully depreciated. When you sell the capital asset, the IRS taxes you on the depreciated portion as an income tax, and that is at the marginal tax rate.

RS Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange.

So, what kind of property qualifies for the 1031 exchange?

To qualify for the special tax-deferment available under a 1031 exchange, you must sell and purchase property of a "like-kind", meaning the property you buy must be similar in nature to the property you just sold.

Generally, as long as you are dealing in real estate, it makes no difference what kind of real estate you buy, because all real property qualifies as like-kind. So you can sell farm property and use the money to buy apartment units, and you probably still qualify.

If you just made a profit from selling a piece of property, or are looking to sell some property, but would like to postpone giving the IRS their share of your profit, that's were a real estate exchange or 1031 property exchange comes in. If you re-invest in an equal or higher-priced property than the one you just sold, the IRS will allow you to defer the payment of the capital gains taxes you would have to pay on the money you just made when you sold your property. Gain deferred in a like-kind exchange under IRS Section 1031 is tax-deferred but not not tax-free.

If a real estate exchange looks like the right investment for your money, than let’s take a more detailed look at some guidelines and timelines imposed by the IRS.

Apart from the two properties involved having to be held for investment and being like-kind, the 1031 exchange also requires that the proceeds from the sale must go through the hands of a qualified intermediary and not through your hands or the hands of one of your agents or else all the proceeds will become taxable.

A 1031 Qualified Intermediary (QI) is an independent and professional facilitator who receives the funds. He handles the funds from the original sale and holds the funds until they are needed to purchase the new exchange (replacement) property. The QI then directly delivers the money to the closing agent who then, in turn, delivers the deed directly to the real estate investor himself (that would be you). Of course the QI is also responsible for providing all necessary legal documents for the transactions.

There are numerous QIs providing "like-kind" 1031 exchange services today, but, in selecting one, you need to make sure they are bonded and insured.

Also, keep in mind that the entire cash or monetary proceeds from the original sale has to be reinvested towards acquiring the new real estate property. Any cash proceeds retained from the sale are taxable.

As another fundamental rule, the 1031 exchange requires that the replacement property must be subject to an equal or greater level of debt than the property sold or, as a result, you will be forced to pay the tax on the amount of decrease.

If not, you will have to put in additional cash to offset the low debt amount on the newly acquired property.

On top of abiding to all the rules mentioned above, you also need to strictly respect the two timelines imposed by the IRS.

The Identification Period: This is the period during which you must identify replacement properties that you would like to buy. It is not uncommon to select more than one property. This period is scheduled as exactly 45 days from the day of selling the relinquished property. Any property received during the identification period is considered to have been identified. This is a very strict rule and there are no extensions because of holidays, illness, or anything else. 

The Exchange Period: This is the period within which, after having sold your relinquished property, you must receive the replacement property. This period ends at exactly 180 days after the date on which you transfer the relinquished property or the due date for your tax return for that taxable year in which the transfer of the relinquished property has occurred, whichever situation is earlier.

Now, according to the 1031 exchange (IRS) rule, the 180 day timeline has to be adhered to under all circumstances and is not extendable in any situation, even if the 180th day falls on a Saturday, Sunday or legal (US) holiday.

Say, for instance, that you began the 1031 like-kind exchange on December 20, 2010 when the property you were selling closed escrow. By early April 2011 you have identified the replacement property and escrow will close at the end of the month. On April 14 you file your tax return. Even if it is clear that you are well within the 180 day time limit, you are NOT eligible for the like-kind exchange for the simple reason that you filed your tax return on time, but before you received the replacement property.

Of course, you could have filed an extension for your income tax return and wait to file until after the replacement property had been transferred.

There are many more rules and guidelines provided by the IRS to cover all imaginable circumstances for a 1031 exchange, so here are a few more rules which may be of interest:

As mentioned before, you can identify more than one replacement property.  Regardless of the number of properties you give up, the maximum number of replacement properties you can identify is the larger of the following:

• Three, or

• Any number of properties whose total fair market value (FMV) at the end of the identification period is not more than double the total fair market value, on the date of the transfer, of all the properties you give up.

If you have a loss on a like-kind exchange, the loss is NOT deductible.

Real property located in the United States and real property located outside of the United States are not considered like-kind property under the like-kind exchange rules. If you exchange foreign real property for property located in the United States, your gain or loss on the exchange is recognized by the IRS.

Relatives are allowed to exchange investment real estate, if they meet the IRS criteria above, and defer taxes in the process.  If either party, however, disposes of the property within two years after the exchange, the tax free exchange is disqualified.

The exception to this is if one of the people involved in the exchange of real estate dies. 

As you can see, 1031 exchanges can become extremely complex in some situations. The money you will save from tax deferment easily justifies paying an attorney or other professional to help you with the 1031 exchange process. They will make sure you meet all the deadlines, file all the necessary paperwork, and don't do anything wrong. Doing a 1031 exchange on your own could result in a mistake which may cause you to lose the tax-deferment and also have to pay the IRS interest or late penalties.