THE 1031 TAX FREE EXCHANGE
By: Richard S. McNeese

If you are an investor in real estate you should be familiar with Section 1031 of the Internal Revenue Code. That Section is one of the last available tax shelters which allows investors to defer paying taxes when investment property is exchanged.

The general rule is that if real estate is sold in a typical sale transaction, gain or loss will be recognized. However Section 1031 basically provides that the gain or loss will not be recognized if the property was business or investment property which is exchanged for “like kind” property.

Say you purchased investment property in the Florida Panhandle a few years ago, and with the appreciation that we have experienced in recent years, you have realized a gain of $300,000 and now wish to sell. Under the new capital gains rates effective as of May 5, 2003, you may be writing a check for $45,000 (15%) to Uncle Sam for capital gains taxes. If you planned to invest in another investment property, Section 1031 will let you keep the $45,000 and roll it into your next property provided all of the requirements of Section 1031 are strictly complied with.

While the provisions of Section 1031 apply to other properties, this article addresses only real estate.

HOW AN EXCHANGE WORKS

While it occasionally happens that two property owners want to trade each other’s properties, the typical exchange involves three parties: the investor (exchangor) who wishes to dispose of property and delay taxation, the buyer for that (relinquished) property, and the seller who is selling to the exchangor the new (replacement) property. Prudent investors follow the “Safe Harbor” provisions of the tax code to prevent actual or constructive receipt of the exchange proceeds which would otherwise disqualify the exchange for Section 1031 purposes and use the services of a “Qualified Intermediary” who becomes a fourth party in the exchange process. The steps for completing the exchange are relatively simple.

• The exchangor signs a contract to sell a relinquished property to the buyer.
• The exchangor assigns the exchangor’s rights in the contract to the Qualified Intermediary.
• At the closing of the relinquished property the exchange funds are deposited with the Qualified Intermediary who instructs the settlement agent to transfer the deed directly from the exchangor to the buyer.
• The exchangor has a maximum of 180 days in the exchange period (or until the tax filing deadline, including extensions, for the year of sale of the relinquished property), to acquire all replacement properties.
• Unless the exchangor can acquire all replacement property within the first 45 days from the close of relinquished property, the exchangor must identify possible replacement properties in writing to the Qualified Intermediary within the 45 day identification period.
• The Exchangor signs a contract to purchase the replacement property with the seller and assigns the contract to the Qualified Intermediary.
• At the closing of the replacement property the Qualified Intermediary forwards the exchange proceeds to the settlement officer together with instructions to transfer the deed directly from the seller to the exchangor.

LIKE KIND PROPERTY

Like kind property refers to the nature, character, or class of the property—not to its grade or quality. Thus an exchange of real estate for real estate is a like-kind exchange. It doesn’t matter where the property is located or whether it is improved or unimproved. So a condominium held for investment can be exchanged for a beachfront lot, an apartment building for a farm, or a shopping center for timberland. So long as the exchange involves business or investment property (and not involving the exchangor’s personal residence) the transaction should qualify for Section 1031 treatment (unless the exchangor is a dealer in real estate and is therefore subject to ordinary income rather than capital gains tax treatment).

A WORD OF CAUTION

While Section 1031 exchanges are relatively uncomplicated, the rules must be strictly followed—especially those regarding time limits and receipt of exchange funds. You should consult with your attorney and/or tax advisor for advice prior to entering into such a transaction. Your real estate agent may also be able to assist you in locating a settlement agent familiar with Section 1031 exchanges as well as a Qualified Intermediary. If done properly, however, a Section 1031 exchange can be a great way to defer taxes and take further advantage of the investment opportunities which exist in the Florida Panhandle.

Richard S. McNeese is the President of McNeese Title, LLC and Destin Title Exchange Company with offices located in Destin, Florida. He has practiced law for 30 years, licensed in Florida and Tennessee, and also has a Bachelor’s Degree in Real Estate.