The §1031
Tax Deferred
Exchange

Uncle Sam's Generous Gift
To Real Estate Investors

What Is A §1031 Exchange?
A §1031 Exchange (sometimes called a Starker Exchange) refers to Section 1031 of the Internal Revenue Code and it offers real estate investors an excellent opportunity to build wealth while saving taxes. By completing a §1031 Exchange an investor can dispose of one investment property, use all of the equity to acquire a different investment property, defer (not avoid) the payment of capital gains & "depreciation recapture" taxes and leverage all of the equity from the original property into the replacement property. The end result is that you "sell" one property, "purchase" a replacement property and defer payment of federal taxes that would have been due on the sale of the initial property.

A Quick Overview Of The Process
The process is slightly complex and only careful compliance with IRS regulations and procedures will guarantee your qualifying for the tax benefits of a §1031 exchange.

Some basic requirements are:

• All properties in the exchange must be within the United States.
• The properties must be either "held for investment" properties or "held for productive use in a trade or business" properties.
• 100% of the equity from "the sale" of the initial property must be rolled over into the replacement property.
• Title must stay the same. Whoever held title to the original property must end up as the titleholder of the replacement property.
• The sale (Phase 1), the purchase (Phase 2) and the transfer of funds must be routed through "an arm's length" intermediary.
• At no time may the investor take possession of the funds.

The original investment property is called the relinquished property and the new investment property is called the replacement property. When ownership of the relinquished property is transferred to the new owner, the net proceeds are placed in escrow with a qualified intermediary (a person or entity not related to the exchanger). The investor then has 45 days from the date of closing on the relinquished property, to identify the replacement property (or properties) and 180 days from the date of closing to actually take title to the replacement property.

For tax computation purposes, the tax basis of the old property becomes the tax basis of the new property. Thus, when you ultimately sell the replacement property, your tax accountant (and the IRS) will compute your gain as the difference between your original tax basis plus any improvements) and the sale price. In other words, the profit (gain) you deferred declaring as a result of the §1031 Exchange will ultimately be taxed when you sell the replacement property

Words Of Caution:

• Form is more important than substance. To insure a transaction qualifies as a §1031 exchange, it is essential that events occur in a certain sequence and documents include specific language. All documents should be prepared and reviewed by an experienced professional, who is familiar with this type of real estate transaction. While it may appear as if you are simply selling one property to purchase another, it is extremely important to follow the IRS protocol precisely to avoid being slammed with a huge tax bill.
• The mandated deadlines in a §1031 exchange are carved in stone ... no extensions ... no exceptions ... weekends & holidays count. It's a good idea to have the replacement property targeted before you start. It is often difficult to locate replacement properties within the short 45 day period.
• You cannot control or take possession of the proceeds generated by the transfer of ownership of the initial (relinquished) investment property. The proceeds must be isolated in an intermediary's escrow account and used ONLY for the purchase of a replacement property.
• Have your plan well defined before you even put the initial property on the market. It is impossible to convert a regular sale into a §1031 exchange once the wrong documents have been signed, money has been exchanged between the wrong parties or the initial property has been sold.
• The exchange must be documented on a single tax return. If your tax return for the following year comes due during the 180 day period, you will either have to complete the §1031 transaction before your tax filing deadline or request an extension of your tax filing deadline.

The §1031 Exchange is definitely a valuable tax shelter but the question remains, why would anyone want to exchange properties in the first place?

1. Recharge your depreciation deduction. Exchange your current property (that you've "depreciated down") for a new investment property of higher value and begin depreciating the new value.
    
2. Consolidation. Exchange several smaller investment properties for a single, more valuable property.
    
3. Diversification. Exchange a large investment property for several smaller properties - perhaps to divide an estate among children.
    
4. Relocation. Exchange an investment property in your old "neighborhood" for a property located closer to where you live now so you can better manage your investment.
    
5. Adjust your plan. Exchange unimproved property (i.e. vacant land) for improved property, residential rental property for retail space, office buildings for warehouses, etc.
    
6. Refinancing. Exchange a property that is difficult to finance (i.e. unimproved property such as vacant land) for a property that will support a loan.
    
7. Improve cash flow. Exchange a property that has already appreciated in value but provides low cash flow for a new property that has a better cash flow.
    
8. Improve growth. Exchange a property with cash flow for a property with more appreciation (growth) potential in order to build your estate.
    
9. Unload white elephants. Exchange unusual or "unique" properties for properties that have broader appeal and will be easier to sell in the future.
    
10. Reduce management headaches. Exchange properties that require a great deal of attention for lower maintenance properties.
     
11. Acquire a business location. Exchange a "held for investment" property for a "productive use" property that you will utilize for your business. Example: Exchange a residential rental property for a professional office or commercial property in which you plan to locate your business.
     
12. Independence . Exchange a property in which you have a partial ownership for a property in which you'll have 100% ownership. Often one partner is buying out the other's interest in the first property.
     
13. Acquire a future retirement residence (at today's prices). Exchange an investment property for a single family residence that you initially treat as an investment/rental property but, in the future, you plan to use the property as your primary residence. (aka - your retirement home).
     
14. Adapt to the economic environment. Exchange a property located in an area not likely to appreciate in value for a property located in an area more likely to grow in value. (i.e. during good economic times, properties in resort areas tend to appreciate rapidly).