A 1031 Exchange (Tax-Deferred Exchange) Is One Of The Most Important Tax Deferral Strategies Remaining Available For Taxpayers. Section 1031 of the Internal Revenue Code is the basis for tax-deferred exchanges. Taxpayers will avoid or minimize income taxes on the sale of property if they reinvest the proceeds in similar or like-kind property.
The 1031 Exchange Advantage permits a taxpayer to sell income, investment or business property and replace the same with like-kind Replacement Property but without having to pay federal or state income taxes on the transaction. A sale of property and subsequent purchase of a Replacement Property does not work; there must be an Exchange. The legal documents and the form of the transaction will determine if there is a 1031 exchange. The party’s intent is only one aspect. The sale and purchase escrows must be related in some aspect.
The Disadvantages of a Section 1031 Exchange include a reduced basis for depreciation deductions on the Replacement Property. The tax basis of Replacement Property will be the purchase price of the Replacement Property minus the gain which was deferred on the sale of the Relinquished Property as a result of the exchange. As a result, the Replacement Property includes a deferred gain that will be taxed in the future if the taxpayer cashes out of their investment.
Exchange Techniques. There is more than one way to structure a tax-deferred exchange under Section 1031 of the Internal Revenue Code. However, the 1991 “safe harbor” Regulations established procedures which include the use of an Intermediary, direct deeding, the use of qualified escrow accounts for temporary holding of “exchange funds” and other procedures which have Congressional and IRS approval. Therefore, the exchange needs to be structured to comply with IRS regulations. As a result, exchanges commonly use the services of a facilitator known as a Qualified Intermediary.
Exchanges can also occur without the services of an Intermediary when parties to an exchange are willing to exchange deeds or if they are willing to enter into an Exchange Agreement with each other. However, two-party exchanges are uncommon since, in the typical Section 1031 transaction, the seller of the Replacement Property is not the buyer of the taxpayer’s Relinquished Property.