The 1031 exchange, also termed the Starker exchange or tax-deferred exchange, allows you to sell investment property and to defer capital gains and depreciation recapture taxes. Assuming that you are reinvesting 100% of the equity into “like-kind” property of equal or greater value. “Like-Kind” property is any property held for investment purposes. The idea behind 1031 exchange is that when an owner has reinvested the sale proceeds into another property, the economic gain has not yet been realized in a way that generates funds to pay any taxes. In other words, it would be unfair to tax a person on a paper gain, so to speak.
It is important to note that the 1031 exchange merely defers the tax. If and when the investment property is ultimately sold, the original deferred gain plus any additional gain realized, is subject to tax.
There are five different types of 1031 exchanges. There is the Simultaneous Exchange, which is when the exchange of the relinquished property occurs at the same time. The Delayed Exchange is common and occurs when there is a time gap between the transfer of the relinquished property and the acquisition of the replacement property. Next, the Build-to-Suit Exchange allows for the taxpayer to build on or make improvements to the relinquished property, using the exchange proceeds. The Reverse Exchange is when the replacement property is acquired prior to transferring the relinquished property. Finally, the Personal Property Exchange is when exchanges are not limited to real property; meaning personal property can also be exchanged for other personal property of like-class.
The advantages of 1031 Exchange are that there are relatively few other methods available for postponing taxes on the sale of an investment property. Another advantage of the exchange is that when you defer the tax you then have more money available to invest with. Also, any gain from depreciation recapture is postponed. The other benefit of the 1031 Exchange is that you can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.
The disadvantages of the 1031 Exchange are that you will have a lower depreciation schedule when you go to acquire new properties and that losses on your income tax return cannot be deducted if you exchange property rather than sell it. Therefore, if you do not want to take a loss, call it a sale and not an exchange.
In summary, the requirements for 1031 Exchange are rather simple. First, an actual exchange must take place. Second, the transfer must involve real property for real property. Additionally, the properties that are sold and acquired by you must be held for productive use in a trade, business or as an investment. There is a 45 day and a 180 day maximum timing requirement for identifying and acquiring replacement property. Finally, Section 1031 is mandatory, meaning that if you fulfill the prior requirements, then the IRS will consider your action an exchange even if you did not intend for it to be so.