Internal Revenue Code Section 1031
Section 1031 of the Internal Revenue Code related to the disposition of property that is held for use in productive trade or business or held for investment. If performed properly, code section 1031 provides an exception to the rule requiring recognition of gain upon the sale or exchange of property. In other words, if the requirements of a valid 1031 exchange are met, capital gain recognition will be deferred until the taxpayer chooses to recognize it. This basically results in an interest free loan from the IRS on the taxes which otherwise would be payable in the year of disposition of the property.

For an exchange to be one hundred percent tax deferred, the Exchanger must acquire replacement property that is of equal or greater value and spend all of the net proceeds from the relinquished property.

What is 1031 Tax Free Exchange?
A tax-deferred exchange is a sale of the relinquished property to one party and a purchase of the replacement property from another property. Many specific requirements must be satisfied in order to complete the exchange properly. When this certain criteria is met, as defined in Internal Revenue Code Section 1031, the taxes on any capital gain realized from the sale of the relinquished property are deferred. The transaction is basically little different from an ordinary sale and purchase of property, except that certain documentation must be present to show that the transfers are intended to be part of an exchange and not a sale. Overall, exchanges represent a legal tax deferral strategy, which allows investors and property owners the opportunity to move equity from one investment to another.

What Are The Different Types Of Exchanges?
To qualify as a Simultaneous Exchange, both the relinquished property and the replacement property must close and record on the same day. There is significant danger and legal exposure in this attempt since many unforeseen events can cause the closing and recordation to be delayed on one of the properties, leaving the investor with a failed exchange and the obligation of taxes that would otherwise be deferred. However the 1031 regulations contain what is referred to as a "Safe Harbor" provision, which does provide that in the event a facilitator or intermediary is used in a simultaneous exchange, and the transaction proves not to be simultaneous, the exchange will not fail simply for that reason.

The Delayed, or Starker exchange is the most common type of exchange today. The IRS formally recognized the delayed exchange for the first time in 1984. In this exchange, the relinquished property is sold at Phase 1, and after a delay the replacement property is acquired at Phase 2. There are time constraints and rules that must be followed for the exchange to qualify for deference.

The Improvement and Construction exchange is when the replacement property requires new construction or significant improvements to be accomplished. These changes are completed to make the property viable for the specific purpose the exchangor has in mind for the property. Such construction or improvements can be completed as part of the exchange process. Therefore, if the replacement property is of lesser value than the relinquished property at the time of the original transaction, the improvement or construction costs can bring the value of the replacement property up to an exchange level that would allow the transaction to remain tax-deferred.

What Requirements Must Be Met For A Delayed Exchange?
There are three basic exchange rules must be met to fully defer taxes on the gain realized from the sale of the relinquished property:

The purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property, all equity received from the sale of the relinquished property must be used to acquire the replacement property, Property that qualifies for exchange under 1031 must be "like kind".

What Is A 1031 "Like Kind" Property?
Property held for productive use in a trade or business, such as income property, or
Property held for investment.  It is not required that exactly the same type of property is exchanged. Therefore, not only is rental or other income property qualified, so is unimproved property that has been held as an investment. The unimproved property can be exchanged for improved property of any type, or vice versa. Also, one property may be exchanged for several, or vice versa. This means that almost any property that is not a personal residence or second home is eligible for exchange under Section 1031.

What Are The Time Constraints For A 1031 Delayed Exchange?
The Exchanger has a maximum of 180 days from the closing of the relinquished property or the due date of that year's tax return, whichever occurs first, to acquire the replacement property. This is called the Acquisition Period. The first 45 days of that period is called the Identification Period. During the 45 days, the exchangor must identify the property, which will be used for replacement. The identification must be in writing, signed by the exchangor and, received by the facilitator or other qualified party, faxed, postmarked or otherwise identifiably transmitted (such as Federal Express or other dated courier service). This must all occur within the 45-day period. Failure to accomplish this identification will cause the exchange to fail.

What Qualifies A Correct Identification?
Three rules exist for the correct identification of replacement properties:
The Three Property Rule dictates that the investor may identify three properties of any value, one or more of which must be acquired within the 180 Day Acquisition Period.

The Two Hundred Percent Rule dictates that if three or more properties are identified, the aggregate market value of all properties may not exceed 200% of the value of the property, which was sold.

The Ninety-five Percent Exception dictates that in the event the other rules do not apply, if the replacement properties acquired represent at least 95% of the aggregate value of properties identified, the exchange will still qualify.

These identification rules are absolutely critical to any exchange. No deviation is possible and the IRS will grant no extensions.

Parties Involved In The Exchange Transaction
Broker/Agent: The broker/agent is involved in performing the sales and purchases of the "like kind" property. Clearly understanding the exchange concept, the agent/broker should work closely with the Qualified Intermediary to avoid pitfalls and give guidance throughout the process.

Qualified Intermediary: The Intermediary is the entity, which structures, consults, guides and documents the exchange transaction from beginning to end. A sound Intermediary will provide safety and securities for the funds held and provide the technical experience needed to maintain the integrity of the exchange.

Escrow/Title: The Escrow Holder/Closing Agent is responsible for properly documenting the exchange with the help of the Intermediary. The teamwork between the Closing Agent/Escrow Officer and the Intermediary is the most important aspect of a successful exchange team.

Tax/Legal Advisors: Many taxpayers will include the advice or guidance of competent advisors prior to the exchange. Advisors will typically interface with the Intermediary.

Disclaimer
This material is designed to only provide information concerning I.R.C. Section 1031 Tax-Deferred Exchange. It is not intended to provide or replace legal, accounting or other professional counsel. It is recommended that you consult with your company management and/or tax counsel regarding any specific situations or how the information contained in this material relates to your company's policy and/or local practices.