A tax deferred exchange represents a simple, strategic method for selling one qualifying property and the subsequent acquisition of another qualifying property within a specific time frame.

Although the logistics of selling one property and buying another are virtually identical to any standard sale and purchase scenario, an exchange is different because the entire transaction is memorialized as an exchange and not a sale. And it is this distinction between exchanging and not simply selling and buying which ultimately allows the taxpayer to qualify for deferred gain treatment. So essentially, sales are taxable and exchanges are not.

WHY CONSIDER IT?

Often seniors live in a single family home that exceeds their needs. A smaller home with less maintenance maybe desirable coupled with keeping the larger home as a rental. The problem is that the return on investment (ROI) for single family homes is typically poor. Multi-unit dwellings (4-plexes, apartments, etc.) provide owners a much better ROI. However, for seniors in California, selling their their primary residence may mean paying significant capital gains taxes if the appreciation on their home exceeds $250,000 for a single person or $500,000 for a married couple. The 1031 Exchange allows a homeowner to first convert their home into a rental (typically for a minimum of two years) and then sell it and buy a better investment property of equal or greater value without paying any taxes.

Internal Revenue Code, Section 1031
Because exchanging represents an IRS-recognized approach to the deferral of capital gain taxes, it is important for us to appreciate the components and intent underlying such a tax deferred or tax free transaction. It is within Section 1031 of the Internal Revenue Code that we find the core essentials necessary for a successful exchange. Additionally, it is within the Like-Kind Exchange Regulations, previously issued by the Department of the Treasury, that we find the specific interpretation of the IRS and the generally accepted standards and rules for completing a qualifying transaction. Throughout the remainder of this booklet we will be identifying these rules and requirements, although it is important to note that the Regulations are not the law. They simply reflect the interpretation of the law (Section 1031) by the Internal Revenue Service.

Basic exchange rules
Let us look at a basic concept, which applies to all exchanges. Utilize this concept to fully defer the capital gain taxes realized from the sale of a relinquished property:

The purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property, and
All equity received from the sale of the relinquished property must be used to acquire the replacement property.

To the extent that either of these rules is abridged, a tax liability will accrue to the Exchangor. If the replacement property purchase price is less, there will be tax. To the extent that not all equity is moved from the relinquished to the replacement property, there will be tax. This is not to say that the exchange will not qualify for these reasons; partial exchanges do in fact qualify for partial tax deferral. It simply means that the amount of any discrepancy will be taxed as boot, or non-like-kind, property.

Four common exchange misconceptions:

All exchanges must involve swapping or trading with other property owners. (NO)

Before delayed exchanges were codified in 1984, all simultaneous exchange transactions required the actual swapping of deeds and simultaneous closing among all parties to an exchange. Often times these exchanges were comprised of dozens of exchanging parties as well as numerous exchange properties. But today, there is no such requirement to swap your property with someone else in order to complete an exchange. The rules have been streamlined to the extent that the current process is reflective more of your qualifying intent rather than the logistics of the property closings.
All exchanges must close simultaneously. (NO)

Although there was a time when all exchanges had to be closed on a simultaneous basis, they are rarely completed in this format any longer. In fact, a significant majority of exchanges are now closed as delayed exchanges.
Like-kind means purchasing the same type of property which was sold. (NO)

The definition of like-kind has often been misinterpreted to mean the requirement of the acquisition of property to be utilized in the same form as the exchange property. In other words, apartments for apartments, hotels for hotels, farms for farms, etc. However, the true definition is again reflective more of intent than use. Accordingly, there are currently two types of property that qualify as like-kind:
- Property held for investment, and/or
- Property held for a productive use in a trade or business.
Exchanges must be limited to one exchange and one replacement property. (NO)

This is another exchanging myth. There are no provisions within either the Internal Revenue Code or the Treasury Regulations that restrict the amount of properties that can be involved in an exchange. Therefore, exchanging out of several properties into one replacement property or vice versa, relinquishing (selling) one property and acquiring several, are perfectly acceptable strategies.

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