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Rationale Behind a 1031 Exchange

A 1031 tax deferred exchange is a way of deferring capital gains taxes by exchanging your real property with another of like kind. Also known as a Starker exchange or a like-kind exchange, the transaction refers to the pertinent section in the Internal Revenue Code, Section 1031 – thus the term 1031 tax deferred exchanges.The rationale behind this form of structured sale is that when a property owner reinvests the proceeds of such a sale into another similar property, no recognized gain has been obtained and no funds are generated with which to pay taxes. What occurs is mere conversion of properties. As such, it would be unfair to force the taxpayer to pay tax on a gain that essentially exists only in paper.A 1031 exchange allows the taxpayer to defer paying capital gains tax on the acquired property until it is sold and the property seller decides to hold on to the money instead of using it to buy another property. In this case, the original gain, plus any additional accrued since the property was purchased, will be taxed.Requirements to Qualify for Section 1031For a transaction to qualify under Section 1031, it must meet several requirements. Under the laws and regulations governing Section 1031, the following properties are expressly excluded for use in a 1031 exchange: stocks, bonds, notes, or other securities; certificates of trust; certifications of beneficial interest; other such evidences of indebtedness; inventories; partnership stakes; or property held for immediate resale.Other types of real property are generally allowed.Both the relinquished (sold) property and the property that will replace it must be held for use in a trade or business or for investment purposes. This proper use qualification is why personal residences are generally not qualified for 1031 types of tax deferment.The properties in the transaction must be of like kind, moreover. Overseas properties, even if of the same type as the originator's property, are not considered to be like kind to properties in the United States. Livestock of different gender are not considered 'like kind' for purposes of 1031 exchanges.The relinquished property must be exchanged for other property, not sold and the proceeds used to purchase the replacement property. This, along with the requirement that the taxpayer not have constructive receipt (explained in the succeeding paragraph) of funds, means that the taxpayer cannot set up a bank account whose monies are to be used solely for the exchange.Another requirement is that the exchange be facilitated by a Qualified Intermediary, an independent entity that holds the monies in escrow and is also named the principal in the sale of the relinquished property and the purchase of the replacement property. The use of an intermediary is necessary because under 1031 exchange agreements, the taxpayer must never have what is known as 'constructive receipt' (direct or indirect control or use) of the funds involved, or the exchange is disqualified. This also prohibits the use of close relatives, who may be considered to be under the control of the taxpayer, or such people as legal or financial counsel that the taxpayer has used within the last two years.1031 exchanges must also follow a strict timetable, which depends on the specific kind of exchange entered into. Under the usual delayed exchange, the taxpayer has 45 days from the date the relinquished property is transferred to identify replacement properties, and 180 days to complete the entire exchange.

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