Review The Land Report‘s checklist of key elements to a 1031 Exchange and learn about Exchange Requirements, Qualified Intermediaries, Proper Purpose, and Qualifying Properties.
By Bill Winke
EXCHANGE REQUIREMENT:
The relinquished property (the one you own) must be exchanged for a replacement property (the one you are buying) rather than sold for cash. A Qualified Intermediary uses the proceeds from the relinquished property to buy the replacement property.
QUALIFIED INTERMEDIARY:
A Qualified Intermediary (QI) is the independent party that facilitates a tax-deferred exchange pursuant to Section 1031 of the Internal Revenue Code. The Qualified Intermediary cannot be the taxpayer or a disqualified person.
Acting under a written agreement with the taxpayer, the Qualified Intermediary acquires the relinquished property and transfers it to the buyer. The Qualified Intermediary holds the sales proceeds to prevent the taxpayer from having actual or constructive receipt of the funds. The Qualified Intermediary acquires the replacement property and transfers it to the taxpayer to complete the exchange within the required time limits.
PROPER PURPOSE:

Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify.
The taxpayer’s personal residence does not qualify for a 1031 Exchange.
QUALIFYING PROPERTY:
According to the Federation of Exchange Accommodators (www.1031.org), “Certain types of property are specifically excluded from Section 1031 treatment: property held primarily for sale; inventories; stocks, bonds, or notes; other securities or evidences of indebtedness; interests in a partnership; certificates of trusts or beneficial interest; and choses in action. In general, if property is not specifically excluded, it can qualify for tax-deferred treatment.”
TIME LIMITS:
You have 45 days after you close on the the sale of your relinquished property to identify potential replacement properties. If you don’t notify the Qualified Intermediary of the replacements within this time, the 1031 Exchange fails and you trigger the transfer of assets into your name. You are then responsible for all taxes resulting from the sale. Done right, however, and you have 180 days after the transfer of the relinquished property to close on its replacement(s). Keep in mind that the exchange has to take place within a single tax year.
TYPES OF EXCHANGES
Delayed Exchange: The most common type of exchange, a delayed exchange occurs when there is a time gap between the transfer of the relinquished property and the acquisition of the replacement property. A delayed exchange is subject to strict time limits, which are set forth in the Treasury Regulations.
Simultaneous Exchange: The exchange of the relinquished property for the replacement property occurs at the same time.
Build-to-Suit (Improvement/Construction) Exchange: This technique allows the taxpayer to build on, or make improvements to, the replacement property, using the exchange proceeds.
Reverse Exchange:This is a situation where the replacement property is acquired prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000. These transactions are sometimes referred to as “parking arrangements” and may also be structured in ways that are outside the safe harbor.
Property Exchange: Exchanges are not limited to real property. Personal property can also be exchanged for other personal property of like kind or like class.
TIMING OF 1031 EXCHANGES

An investor empowers a Qualified Intermediary to receive the proceeds from the sale of the relinquished property (the one that’s being sold) and then instructs the Qualified Intermediary to purchase a replacement property. This is the most common form of 1031 Exchange and is called a delayed exchange. A simultaneous exchange is when the Qualified Intermediary sells the relinquished property and closes on the replacement property at the same time.
There’s even a case called the reverse exchange. This occurs when the replacement property is acquired prior to transferring the relinquished property. The reverse exchange was only approved by the IRS in 2000 and requires that the replacement property be “parked” with an entity called an exchange accommodation titleholder, which holds title to the property until the sale of the relinquished property takes place. Two other exchanges exist–the build-to-suit exchange and the personal property exchange–but all of my 1031s have been deferred, and in all likelihood yours will be too.

SHORT-TERM CAPITAL GAINS

What about the taxes you must pay when you finally cash out? The 1031 Exchange is a tax deferral tool, and to defer implies that you will pay later. When you cash out, you will trigger taxes all the way back to the first sale. Some believe that transactions involving properties held for less than a year will be taxed as short-term capital gains even though you used a 1031 to move the proceeds into another parcel.
According to my tax accountant, as long as you hold the final property for at least a year before selling it, you only pay long-term capital gains back to your original basis: the original cost you paid for the first
property. Other accountants interpret this differently. They suggest that you will actually be triggering short-term capital gains on the properties you held for less than a year. My accountant assured me numerous times that this is not true. Be sure to come to a complete understanding of this issue with your own tax accountant before you exchange a property that you have held for less than a year.

DON’T TRY A 1031 EXCHANGE AT HOME
A 1031 Exchange allows you to defer capital gains taxes, but the IRS gets kind of funny when you try to avoid them altogether. That’s why a 1031 Exchange won’t work if you attempt to roll a gain on an investment property (the relinquished property) into an investment that will become your primary residence (the replacement property). Investors occasionally try to use this loophole to eliminate capital gains taxes completely by satisfying the primary residence requirements and then selling their home tax-free. That won’t work. If the replacement property becomes your personal residence, the exchange will fail.