1031 Tax Free Exchange: Flexibility and Tax Protection in One Package

by Peter J. Kelley, Esq.

Whether an owner is a professional real estate investor or an individual with one or two income-producing properties, opportunities frequently arise that require the sale of one property and the acquisition of another.  It may be a simple consequence of relocation to a new city.  Or retirement may make it inconvenient to supervise a property.  Market conditions might favor selling a building whose value has peaked and reinvesting in a location with a rising market.

The spectre of capital gains taxation could squelch such opportunities – except for the provisions of Section 1031 of the Federal Tax Code.  This statute offers owners of investment or income producing property the opportunity to sell and purchase replacement properties without liability for Federal capital gains tax. 

“Like-kind” Property

Called a “tax free exchange,” the rule applies not only to real estate but to other forms of investment property – with some limitations, of course.  Business inventory, stock portfolios and other such assets are not eligible.  But most forms of real estate investment property can benefit from Section 1031 treatment. As long as the property being divested and the property being acquired are similar in nature – for example, both are residential real property such as single family or multiple family dwellings, cooperative apartments or condominium apartments – they qualify for tax exempt treatment under Section 1031. 

Straightforward Procedure:

Identify the Property

The procedure is remarkably free of complications.  First, the owner (sometimes called the “Taxpayer” or the “Exchangor”) needs to identify the property to be sold. 

 In IRS parlance, this is called the “Relinquished Property.”  Next, find  an agent to be the “honest broker” in the deal – an independent escrow holder who is not related in business or blood to the parties to the transaction and who can act as the transfer agent for the owner selling the Relinquished Property and purchasing replacement assets.  This agent is known as the “Qualified Intermediary.”  A professional Qualified Intermediary can provide the seller with the documentation needed to do the transactions as contemplated by the IRS rules.  The seller and the Qualified Intermediary (sometimes called the Exchange Agent) enter into an agreement under which the seller assigns his rights under the sale contract to the Exchange Agent to hold pending the purchase of one or more properties to replace the one sold.  That property is called, logically enough, the “Replacement Property.”

The sale of the Relinquished Property proceeds largely as a normal sale.  A buyer is identified, and a contract of sale prepared.  A special contract rider puts the buyer on notice of the 1031 tax free exchange, provides for the buyer to consent to the program, and appoints the Qualified Intermediary as the agent to carry out the sale of the property for the owner.  At the closing, all sale proceeds must go directly to the Qualified Intermediary, who holds them in escrow pending the completion of the exchange.

Find the Replacement Property

From the date of closing of the sale of the Relinquished Property, the seller has 45 days to identify one or more properties “of like kind” to replace the property that was sold.The owner then must enter into contract to purchase the Replacement Property.  Again, the contract will include specific rider language notifying the seller of the 1031 exchange transaction,

 identifying the Qualified Intermediary as the agent for the buyer and providing that the funds for the purchase will be provided from the escrow he is holding.  By law, the purchase of the Replacement Property must take place within 180 days of the closing of the sale of the Relinquished Property.

Taxable “Boot”

If the proceeds of the sale of the Relinquished Property exceed the cost of the new Replacement Property, the excess proceeds (known as the “Boot”) may be taxable at the usual capital gains rates.

Code Section 1031 also offers opportunities for sophisticated and complex exchange transactions that are beyond the scope of this article. But in its basic provisions, the 1031 Tax Free Exchange program can offer remarkable benefits to ordinary property owners.  With the services of an experienced Qualified Intermediary, an attorney familiar with this area of tax law, and an informed broker, the process is generally straightforward and efficient, and has no negative impact on any third party in the sale or purchase transactions.

Peter J. Kelley is an attorney with over 23 years’ experience representing parties in commercial and residential real estate transactions.  He frequently serves as Qualified Intermediary in 1031 Tax Free Exchanges.  He can be reached at (212) 387-7787.