What is a 1031 Exchange?

 The §1031 exchange begins on the earliest of the following:  

1. the date the deed records, or
2. the date possession is transferred to the buyer,

and ends on the earlier of the following:  

1. 180 days after it begins, or
2. the date the Exchanger's tax return is due, including extensions,  for the taxable year in which the relinquished property is transferred.

The identification period is the first 45 days of the exchange  period. The exchange period is a maximum of 180 days. If the Exchanger  has multiple relinquished properties, the deadlines begin on the  transfer date of the first property. These deadlines may not be extended  for any reason, except for the declaration of a Presidentially declared  disaster. A deadline that falls on any weekend day or holiday does not permit  extension. For example, if your tax return is due April 15, but that  date falls on a Saturday, then your tax return due date is forwarded to  the first business day following April 15, or Monday, April 17. However,  if a deadline falls on a Sunday, the requirements for the exchange must  be met no later than the last business day prior to the deadline date,  i.e. the prior Friday. Identified replacement property that is destroyed by fire, flood,  hurricane, etc. after expiration of the 45-day Identification Period  does not entitle the Exchanger to identify a new property. However, the  exchange may be terminated by this event so long as it is (a) specified  in writing (such as a contingency in the sales contract); (b) is outside  the control of the exchanger or any party to the exchange; and (c) is  the only or last property that the exchanger is entitled to purchase  under the exchange rules. Mistakenly identifying condominium A, when condominium B was  intended, does not permit a change in identification after the 45-day  Identification Period expires. Failure to comply with these deadlines  may result in a failed exchange. IRS rules control the length of time that the replacement property  must be held before it may either be sold or used to enter into a new  tax deferred exchange. In highly appreciating markets, people may take  the opportunity of selling their personal residence (where no capital  gain is due below $250,000 for a single person or $500,000 for a married  couple—see Taxpayer Relief Act of 1997)  and moving into a former rental property for a specified time period in  order to turn it into their new personal residence. With recent  legislation, however, capital gains taxes on such a transaction are no  longer completely avoided. The taxpayer will now owe a diminishing  amount of capital gains taxes on the conversion of property from rental  to personal residence once the final disposition of the property occurs. In order to qualify for this exchange, certain rules must be followed:  

1. Both the relinquished property and the replacement property must be  held either for investment or for productive use in a trade or business.  A personal residence cannot be exchanged.
2. The asset must be of like-kind. Real property  must be exchanged for real property, although a broad definition of  real estate applies and includes land, commercial property and  residential property. Personal property  must be exchanged for personal property. (There are some complicated  rules surrounding this — for example, livestock of opposite sex are not  considered like-kind property for the purpose of a 1031 exchange,  and property outside the United States is not considered of "like-kind"  with property in the United States.)
3. The proceeds of the sale must be re-invested in a like kind asset  within 180 days of the sale. Restrictions are imposed on the number of  properties which can be identified as potential Replacement Properties.  More than one potential replacement property can be identified as long  as you satisfy one of these rules:  
   • The Three-Property Rule - Up to three properties regardless  of their market values. All identified properties are not required to be  purchased to satisfy the exchange; only the amount needed to satisfy  the value requirement.
   • The 200% Rule - Any number of properties as long as the  aggregate fair market value of all replacement properties does not  exceed 200% of the aggregate Fair Market Value (FMV) of all of the  relinquished properties as of the initial transfer date. All identified  properties are not required to be purchased to satisfy the exchange;  only the amount needed to satisfy the value requirement.
   • The 95% Rule - Any number of replacement properties if the  fair market value of the properties actually received by the end of the  exchange period is at least 95% of the aggregate FMV of all the  potential replacement properties identified. In other words, 95% (or  all) of the properties identified must be purchased or the entire  exchange is invalid. An exception to the 95% rule is that if you close  on a property within the 45 day period it still qualifies for the  exchange.

 Although it is not used in the Internal Revenue Code, the term "Boot"  is commonly used in discussing the tax implications of a 1031 Exchange.  Boot is an old English term meaning "Something given in addition to."  "Boot received" is the money or fair market value of "Other Property"  received by the taxpayer in an exchange. Money includes all cash  equivalents, debts, liabilities or mortgages of the taxpayer assumed by  the other party, or liabilities to which the property exchanged by the  taxpayer is subject. "Other Property" is property that is non-like-kind,  such as personal property, a promissory note from the buyer, a promise  to perform work on the property, a business, etc. There are many ways for a taxpayer to receive “Boot”, even  inadvertently. It is important for a taxpayer to understand what can  result in boot if taxable income is to be avoided. The most common sources of boot include the following:  

• Cash boot taken from the exchange. This will usually be in the form  of "Net cash received", or the difference between cash received from the  sale of the relinquished property and cash paid to acquire the  replacement property(ies). Net cash received can result when a taxpayer  is "Trading down" in the exchange (i.e. the sale price of replacement  property(ies) is less than that of the relinquished.)
• Debt reduction boot which occurs when a taxpayer’s debt on  replacement property is less than the debt which was on the relinquished  property. As is the case with cash boot, debt reduction boot can occur  when a taxpayer is "Trading down" in the exchange. Debt reduction can be  offset with cash used to purchase the replacement property.
• Sale proceeds being used to pay non-qualified expenses. For example,  service costs at closing which are not closing expenses. If proceeds  from the sale are used to service non-transaction costs at closing, the  result is the same as if the taxpayer had received cash from the  exchange, and then used the cash to pay these costs. Taxpayers are  encouraged to bring cash to the closing of the sale of their property to  pay for the following: Non-transaction costs: i.e. Rent prorations,  Utility escrow charges, Tenant damage deposits transferred to the buyer,  and any other charges unrelated to the closing.
• Excess borrowing to acquire replacement property. Borrowing more  money than is necessary to close on replacement property will not result  in the taxpayer receiving tax-free money from the closing. The funds  from the loan will be the first to be applied toward the purchase. If  the addition of exchange funds creates a surplus at the closing, all  unused exchange funds will be returned to the Qualified Intermediary,  presumably to be used to acquire more replacement property. Loan  acquisition costs (origination fees and other fees related to acquiring  the loan) with respect to the replacement property should be brought to  the closing from the taxpayer’s personal funds. Taxpayers usually take  the position that loan acquisition costs are being paid out of the  proceeds of the loan. However, the IRS may take the position that these  costs are being paid with Exchange Funds. This position is usually the  position of the financing institution also. Unfortunately, at the  present time there is no guidance from the IRS on this issue which is  helpful.
• Non-like-kind property which is received from the exchange, in addition to like-kind property (real estate).

 An investor buys a strip mall (a commercial property)  for $200,000 (his cost basis). After six years he could sell the  property for $250,000. This would result in a gain of $50,000, on which  the investor would typically have to pay three types of taxes: a federal  capital gains tax, a state capital gains tax and a depreciation  recapture tax based on the depreciation he or she has taken on the  property since the investor purchased the property. If the investor  invests the proceeds from the $250,000 sale into another property or  properties (without touching the proceeds and using a Qualified  Intermediary), then he would not have to pay any taxes on the gain at  that time. An owner of a detached house on 3 acres (12,000 m2) is  transferred by his employer to another state. Rather than selling the  home, which will no longer be his personal residence, he chooses to rent  it out for a period of time. After ten years, he decides that he wants  to sell it but, at the same time, he has a grown son who will be going  to college in yet another state. He decides that he wants to buy an  apartment building in the college town for the son and other students to  rent while they are in school. His house has appreciated from $200,000  to $300,000. Therefore, he arranges for an IRS Section 1031 exchange,  and buys the new property, thus avoiding the capital gain at that time. Caution—in the aforementioned example, the investor would need to  substantiate his or her [investment intent] to the IRS by showing an  arm's length lease to the son and other students, and investor should  declare income and take on offseting depreciation deduction. In addition to the sale of real estate, selling an interest in real  property may also qualify for a 1031 Exchange. An example of this would  be the sale of an easement.