The 1031 Tax-Deferred Exchange Confusion
Lawrence D. Elliott
March 13, 2006
I have worked with many new and less experienced investors over the years and I have found an overwhelming common—and expensive—misconception: The “like-kind” rule specified in the rules governing the 1031 Tax-Deferred Exchange (also known as a “1031” or “Exchange”) process means you must exchange for the exact same type of property to get the tax benefit. Nothing could be further from the truth. Not understanding this term could cause you to lose out on profitable financial opportunities.
Now it’s great that they are thinking of an Exchange at all. I once represented a buyer on a property in Rialto, California, and after numerous times asking the seller’s agent whether their client was going to perform one, 3 days before escrow close—on a 45-day escrow period—they wanted to perform one! And the seller was represented to us as an “experienced” investor. Fortunately, we were working with an experienced escrow officer I had great rapport with and she was able to set-up a delayed exchange. She was a lifesaver!
For those who may not know, an Exchange is the method for exchanging one investment property for another one, while deferring the possible capital gains tax. The financial gain you would realize can be deferred as long as you follow the rules set out by IRS Code 1031—where the name comes from—and you use proper professionals who know and understand the process. They should also be able to explain the process to you and help you follow the your requirements under the code. This is important because if there are any mistakes made, you could be left holding the legal and financial bag. That financial bag would be in the form of a healthy tax consequence levied by Uncle Sam! If used correctly, this a true wealth-preserving tool.
And here lies the confusion. According to the IRS, any real property held “for productive use in a trade or business” or “for investment” could be exchanged for “like-kind” property that is also being held for the same purposes. Notice, it does not state “exact-kind” property.
For example, you own a single family rental property in Covina, California. You can exchange that property for a warehouse in Pomona, or a retail center in Upland, or an office building in Ontario, California. The replacement property need not be in the exact configuration as the relinquished property to qualify as an Exchange. However, the IRS code must be followed. It is wise to consult your legal and tax specialists at the same time you are consulting with your Realtor to ensure you comply with all state and federal laws.
In real estate, knowing the rules is very important, but it is also important to work with competent professionals who can keep you out of legal hot water and make your real estate transaction run as smooth as possible. They can also ensure your financial bottom-line doesn’t bottom-out!
Now it’s great that they are thinking of an Exchange at all. I once represented a buyer on a property in Rialto, California, and after numerous times asking the seller’s agent whether their client was going to perform one, 3 days before escrow close—on a 45-day escrow period—they wanted to perform one! And the seller was represented to us as an “experienced” investor. Fortunately, we were working with an experienced escrow officer I had great rapport with and she was able to set-up a delayed exchange. She was a lifesaver!
For those who may not know, an Exchange is the method for exchanging one investment property for another one, while deferring the possible capital gains tax. The financial gain you would realize can be deferred as long as you follow the rules set out by IRS Code 1031—where the name comes from—and you use proper professionals who know and understand the process. They should also be able to explain the process to you and help you follow the your requirements under the code. This is important because if there are any mistakes made, you could be left holding the legal and financial bag. That financial bag would be in the form of a healthy tax consequence levied by Uncle Sam! If used correctly, this a true wealth-preserving tool.
And here lies the confusion. According to the IRS, any real property held “for productive use in a trade or business” or “for investment” could be exchanged for “like-kind” property that is also being held for the same purposes. Notice, it does not state “exact-kind” property.
For example, you own a single family rental property in Covina, California. You can exchange that property for a warehouse in Pomona, or a retail center in Upland, or an office building in Ontario, California. The replacement property need not be in the exact configuration as the relinquished property to qualify as an Exchange. However, the IRS code must be followed. It is wise to consult your legal and tax specialists at the same time you are consulting with your Realtor to ensure you comply with all state and federal laws.
In real estate, knowing the rules is very important, but it is also important to work with competent professionals who can keep you out of legal hot water and make your real estate transaction run as smooth as possible. They can also ensure your financial bottom-line doesn’t bottom-out!
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