Many clients have heard of what a 1031 exchange is or how it can benefit them but do not know how to follow the detailed rules in order to receive the benefits of such an exchange. In general, a taxpayer is allowed by Internal Revenue Code Section 1031 to defer current recognition of capital gains tax on the exchange of property that is held either for productive use in a trade or business or for investment. This type of transaction is commonly known as a tax-deferred exchange or a 1031 exchange.
In simplified terms, a 1031 exchange involves an owner of real property who sells that property (Relinquished Property) and then acquires another property (Replacement Property). The Relinquished Property and the Replacement Property must be held for productive use in a trade or business, or for investment.
In order to qualify for the tax-deferral, the transaction must be an exchange of two properties as opposed to an acquisition of money from the sale of the Relinquished Property and then a purchase of the Replacement Property with those funds.
This means you must not ever actually have the proceeds from the Relinquished Property in your possession but rather must have these proceeds used for the purchase of the Replacement Property. Most often this requires a Qualified Intermediary to hold the proceeds from the Relinquished property, pending acquisition of the Replacement Property, if the exchange transactions are not simultaneous and concurrent.Reverse Exchanges
By far, the most common type of exchange is a 1031 tax deferred exchange. However, in some cases a reverse exchange situation is necessary. This type of exchange is also known as a "Parking Arrangement" and it allows taxpayers some flexibility in the structure of a 1031 exchange transaction. In a reverse exchange transaction, the acquisition of the Replacement Property is through an Exchange Accommodation Titleholder (EAT) which can occur before the Relinquished Property is sold. The Eat then allows the completion of the exchange after the Relinquished Property is sold, in reverse order from a normal forward exchange.
In either case, whether it is a forward or reverse exchange, a 1031 exchange can save you capital gains tax when you want to buy and sell property. This is a useful tool in real estate transactions that many clients have never heard of before. Contact us today and we will be glad to assist you with your 1031 exchange.