What is a 1031 Tax Exchange?

A 1031 tax exchange is a method of transferring the ownership of real property in order to acquire another property that is similar in certain attributes to the first. Since the protocol for engaging in a 1031 exchange dictates that both properties must be similar in kind, these types of transactions are also known as a “like kind exchange” or a “tax deferred exchange.” Perhaps the latter term best describes the transaction since the point of doing one is to defer capital gains tax. In fact, pursuant to Revenue Code Section 1031, the U.S. Internal Revenue Service (IRS) does not acknowledge a gain or loss from the transaction, as long as both properties are, in fact, of like kind.

It’s important to understand that a 1031 tax exchange does not technically constitute a sale, even though the involved parties are usually referred to as Seller and Purchaser. In addition, if there is other real property or currency included in the exchange that is not like kind, then the IRS considers that property to be a financial gain and will impose tax accordingly. Further, the 1031 exchange rule does not apply to securities, such as stocks, bonds, or mortgage notes.

There are other restrictions as well. For instance, while inventory is not eligible as a 1031 exchange, the transfer of livestock may be providing the animals in question are of like kind and also of the same sex. Presumably, the latter requirement may be explained by the difference between the potential financial gain realized from milk-producing female cows, for example, and bulls suitable for breeding. Other exchanges that are not considered like kind are transfers involving one property located in the U.S. and another outside of U.S. territory.

The IRS also stipulates that 1031 exchanges must involve business use properties. In other words, it generally does not apply to residential or vacation properties, even though these types of real estate may be considered investment properties. Either property may be improved or unimproved. However, the property being received must represent a tax liability equal to or greater than the property being transferred. Otherwise, the “buyer” will be subject to paying the difference.

In contrast to the usual transfer of property due to a normal sale, the “seller” of a 1031 exchange property does not receive any cash proceeds. In fact, the entire exchange process is handled by a third party known as a Qualified Intermediary (QI). This party or person cannot be a family member, business associate, or similar individual. In fact, the QI is usually a representative of a business entity that exists solely for the purpose of acting as “an independent and professional facilitator” of 1031 exchanges. The appointed QI serves as liaison between the parties involved in the transaction at every step, including delivering deed and title.

There are certain timelines that apply when initiating a 1031 tax exchange. First, there is the Identification Period, which provides a 45-day window of opportunity for the transferor to identify potential like kind properties suitable for the exchange. This time period expires precisely 45 days from the anticipated date of sale of the first property, even if the last day of the period falls on a holiday or weekend. Secondly, the Exchange Period must be observed. As the name implies, this condition strictly stipulates that the like kind property must be received by the seller within 180 days of transferring the exchanged property, regardless of the last day occurring on a holiday or weekend.