The advantage of a 1031, or “likekind” exchange is that you can defer paying capital gain taxes on the sale of a qualifying (and usually significant asset) by rolling the net sales proceeds from the sale into a similar, or like-kind, property. You can avoid tax until the next asset is sold (which has a reduced cost basis as a result of the gain that was rolled over from the first property) but are able to own something else in the meantime that suits your circumstances better. The IRS’s website has information of exchanges at www.irs.gov/pub/irs-pdf/f8824.pdf and all the specifics are detailed there. Such like-kind exchanges must be handled by a qualified intermediary, the rules are quite stringent and every state has different angles. Current realities with real estate and the economy have made these exchanges significantly less popular than say, two years ago, because people do not have as large gains in their holdings. Frederick is lucky to have a reputable local intermediary, West Patrick Exchange, established by a collaboration of twelve accountants and attorneys (from different companies), that handles like-kind exchanges for taxpayers. Intermediaries act as the escrow agent, handle the paperwork and can provide information to you on the rules and regulations. Your CPA is also able to provide assistance with the very complicated exchange forms that must be completed with your tax returns.

IRS Section 1031 exchanges, or like-kind exchanges, are a good way to defer the taxable gains on the sale of certain types of property. There are two key terms to keep in mind: like-kind exchange and tax deferred (not to be confused with tax free). Section 1031 exchanges are most commonly used with real estate, but can also include other types of property. The properties to be exchanged must be used as an investment, in a business or in a trade. (Note that personal property such as your home or vacation home would not qualify for a 1031 exchange.) In defining “like-kind” the IRS is not concerned with the quality of the property, but rather that the property is of the same nature, character or class. Simultaneously exchanging one type of property for another is the simplest type of exchange. Deferred exchanges are also allowed and there are very specific rules for how these should be structured. Exchanges can include cash, debt relief or property that is not like-kind in addition to the like-kind swap. Any of these types of additions could trigger a taxable liability. A section 1031 exchange can be a powerful tax deferral tool, but require careful record keeping and strict adherence to IRS guidelines. Working with your financial adviser, CPA and a qualified 1031 intermediary will make this process much smoother.

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind,” while deferring the payment of federal income taxes and some state taxes on the transaction. The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031. Finally, certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of: inventory or stock in trade; stocks, bonds, or notes; other securities or debt; partnership interests; or certificates of trust. It is important to know that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make all gain immediately taxable. You should consult your tax adviser before making any major decision that will involve a 1031 exchange.

A 1031 exchange offers many benefits. When done properly, current cash returns can be improved, greater investment appreciation may be gained (without a large tax bill), property can be transferred from one location to another, etc. Make sure you receive good advice on a 1031 exchange. You may need to know if you are allowed to pay off debt on property you already own with proceeds from a 1031, what a “Poor Man's Build to Suit” is, and get a seller to make improvements and raise the selling price before you close the deal. Like I said, get good advice so you have a full understanding of how a 1031 works, as well as all of the advantages and potential pitfalls associated with it.