The primary advantage of exchanging over selling is that the owner may dispose of property without incurring any immediate tax. Permitting the owner-exchanger to retain and reinvest money that would otherwise have been paid in federal and state taxes increases leverage.

In effect, the owner-exchanger receives an interest-free loan from the government. These “loan proceeds” representing your unpaid taxes are invested instead in your replacement property.

Exchangers may continue to avoid taxation (and the corresponding reduction of their estates) as long as they remain invested. At death all tax liability is forgiven and the gains which have accumulated will escape income taxation entirely. The exchanger's heirs get a new, stepped-up basis on inherited property.

More than sheltering the exchanger from tax, the tax-deferred exchange opens other avenues and opportunities the small investor may not have fully contemplated previously.

An exchange can be used to consolidate multiple properties into one property to ease management burdens. A real estate investment can be relocated to a more attractive region. Retirement and estate planning objectives can be combined with exchanging to reach personal goals in a variety of ways.

A tax-deferred exchange is a procedure by which an owner/investor trades one property for another without incurring any capital gains tax on the transaction. Payment of tax is deferred.

This procedure is provided for in Section 1031 of the Internal Revenue Code and is a safe and inexpensive way to achieve significant tax savings.

Current practice calls for the owner's sale and reinvestment transaction to be converted into an exchange through the services provided by and only by a Qualified Intermediary, the use of prescribed written documentation and accomplished within set time limits.

First, explore the exchange option with your personal tax advisor, attorney or accountant. Find out if the disposition of your property triggers a taxable gain. It's a good idea to do the tax calculation before you decide on your course of action. Know what the tax bite would be in the event of a sale.

Then, market your property in the usual manner. Add a provision in all binding purchase and sale contracts obligating the other party to cooperate with you in the exchange. LEX will provide the protective 1031 provision for you should your real estate agent be unfamiliar with exchanging. Many printed form purchase and sale contracts have a check-the-box item for tax-deferred exchanging.

When the contract to dispose of your old property is firm and you are ready to open escrow or begin the closing process, contact LEX and complete the start form provided on this site or call  for further assistance.

Avoidance of tax demands that the owner-exchanger trade for property that is like-kind.

Fortunately, all interests in real estate are considered to be like in kind to any other whether improved or not.

For example, the following types of real property are considered to be of like-kind:

• A single family house for a duplex
• Unimproved land for commercial income property
• Ranch or farmland for city condominiums
• A lease of 30 years or more for a fee interest
• A co-tenancy interest for sole ownership in realty
• A conservation easement for a fee interest in an apartment building

But, U.S. realty is not permissibly traded for foreign realty.

The Qualified Intermediary is the party who participates on behalf of the owner-exchanger by transferring and acquiring the exchange properties and holding the proceeds of sale. Nearly all exchanges today are handled by professional QIs.

The widespread use of QIs solves the practical difficulty the owner-exchanger would otherwise face in finding a suitable exchange partner and property in the marketplace by substituting a “straw man” to facilitate the trade.

More importantly, the risk of disqualification and denial of benefits is substantially reduced when the owner chooses to use a party the IRS defines as a “Qualified Intermediary.” LEX meets the definition of a Qualified Intermediary.

The owner-exchanger may not use his or her real estate agent, accountant, personal attorney or family member to handle an exchange. These are deemed to be related or controlled parties by the IRS and can cause denial of tax-deferred treatment.

Identification of all replacement property must be made in writing, signed by taxpayer, and received by the QI on or before the 45^th day of the exchange period. The exchange period begins on the date the relinquished property escrow is closed.

On a form provided by LEX, the taxpayer provides the QI with the street address or legal description of the candidate property and its fair market value (FMV). If an improvement exchange is planned, the improvements must be described in as much detail as reasonably practical.

The taxpayer may identify one or more properties on the identification form.  In general, the number of replacement properties that may be permissibly identified are:

1. Up to three properties without regard to their FMV, called the Three-Property Rule;
2. If more than three properties, the total FMV of all properties identified may not exceed 200% of the total selling price of all properties relinquished (the 200% Rule).

Should identification fail to qualify under either the Three-Property Rule or the 200% Rule, then the properties acquired after the 45th day do not count as valid replacement property unless the taxpayer acquires 95% of all the identified properties.

Unless the exchange of properties is done simultaneously (only a small number of trades are now done this way), the replacement property must be:

1. Identified no later than 45 calendar days after the date on which the old or relinquished property is transferred (typically the closing date of escrow), and
2. Acquired on or before 180 calendar days after the old property is transferred.

Should the owner-exchanger's tax return due date occur during the 180 day period, it is necessary to obtain an extension of time to file in order to obtain the full 180 days. Otherwise, the due date can cut down the acquisition period and cause loss of tax deferral!

Except in certain officially declared emergencies, the government will not extend these time limits. They must be met to qualify for the benefits afforded under Section 1031.

Yes. You may use the tax-deferred exchange provisions for the rental portion of your multi-unit real estate by allocating an appropriate share of the price to such units. Use either a price per unit method or a square foot measurement to calculate the allocation.

You can also apply the personal residence tax exclusion (IRC Section 121) to the unit in which you have lived for at least two of the past five years. These two tax provisions can be used in combination to achieve remarkable tax savings (See Answer to Question 18).

No. But to defer all taxes, the exchanger must reinvest all cash realized in the transaction. To the extent part of the cash realized is taken out of the sale escrow, such proceeds will be subject to taxation.

Once proceeds are in possession of the Intermediary, 1031 rules limit disbursement of funds to or for the benefit of taxpayer until either (a) all identified property to which taxpayer is entitled has been acquired or (b) the expiration of the 180 day exchange period.

A superior alternative for the exchanger who wishes to defer tax and also obtain some cash is to borrow following receipt of the replacement property. Borrowing secured by the replacement realty is normally non-taxable.

Borrowing against the old exchange property just prior to or in anticipation of the exchange poses unnecessary tax risk and is not advised.

Scaling down from a property of greater value to one of lesser value unavoidably results in the exchanger receiving either some cash or a reduction in the mortgage owed after the exchange is completed. Both the receipt of cash and a reduction of debt owed are “unlike” property received and are subject to tax. Tax practitioners call this kind of unlike property “boot.”

A simple rule to remember and apply when avoidance of all tax is your goal: ALWAYS TRADE ACROSS OR UP IN BOTH EQUITY AND VALUE WHEN EXCHANGING.

Here's a simple example. The exchanger's old property is "A" and the replacement properties are "B."

In this situation , the exchanger traded across in equity and up in value and avoids receiving "boot." But if the exchanger traded down to a property worth only $600,000 with his/her $400,000 equity, the mortgage debt would be reduced by $50,000. A tax on the $50,000 debt reduction would be imposed.

There are “boot netting” rules which can be applied to save or avoid tax in certain situations but the applicability of such rules to any individual transaction is beyond the scope of this page. Following the simple rule stated above will preserve your tax benefit but is not a replacement for doing the actual calculation for each individual transaction. Always seek the assistance of your own personal tax advisor before exchanging.

Both the property given up (the old property) and its replacement must be held or intended for use by the owner-exchanger for productive use in a trade or business or for investment. This is known as a “qualified use” or as “qualified use property.”

For example, property used to generate rental income or property used in the owner's business meets the “qualified use” test. Vacant land and unproductive property held by a non-dealer for future use or for appreciation meets the held for “investment” requirement and is a “qualified use” under Section 1031.

But property used for personal reasons (for example, a personal residence) or primarily for sale as stock in trade (like inventory) or intended for quick re-sale is not entitled to tax-deferred treatment. 1031 benefits are not allowed when "flipping" property.

Unfortunately, there is no fixed holding period set by law for “qualified use property.” IRS scrutinizes taxpayer's “intent” at the time property is acquired.

All surrounding facts and circumstances are taken into account: time, taxpayer's ordinary business, number of sales/re-sales, and property utilization. Many Intermediaries recommend a holding period in at least part of two successive tax years. Some view one year's time is sufficient. On good facts showing non-tax driven transfers, courts have approved a six month holding period.

Its a 1031 exchange in which the replacement property is improved to the exchanger's specifications before it is transferred to the exchanger.

Planned improvements must be carried out within the 180 day exchange period in order to receive tax-deferred treatment. This can be a challenging task.

In an improvement exchange, the responsibility for ownership and disbursement of exchange funds is lodged with the Qualified Intermediary (QI), although the exchanger may act in a consultative or advisory capacity, approving development steps and authorizing outlays in accord with a predetermined plan.

Because the QI is the title holder throughout the exchange period, payment of liability and workers' compensation premiums, management fees and other costs makes the improvement exchange a substantial financial undertaking.

Improvement and Reverse exchanges are referred to specialists by LEX.

A reverse exchange is the popular name given to one method of structuring a transaction when taxpayer must or wishes to acquire replacement property before having disposed of the old property. These kinds of transactions are also referred to as parking exchanges because the replacement property is typically acquired by the Qualified Intermediary (QI) on taxpayer's behalf and “parked” in a specially formed entity (an LLC is the usual choice) until it can be traded with the exchanger upon sale of the old property.

IRS has issued “safe harbor” rules expressly permitting the acquisition of replacement property before selling the old property as long as certain requirements are met. The LLC must be considered the owner for federal income tax purposes, the 45-day identification and 180-day exchange time limits must be observed and specially crafted contractual provisions need to be followed.

In a parking exchange the QI's role is significantly broadened, as are transaction costs. The QI arranges for formation of the LLC which holds title to at least one of the properties for a time. Even though the exchanger/client is allowed to manage the property, the QI takes on the duty of collecting and reporting income and operating costs as would a real owner.

Because of increased transaction costs and extra management burdens, the would-be reverse or parking exchanger should always explore alternate ways of accomplishing their objectives.

For example, the taxpayer might secure the replacement property by entering into a lease with an option to purchase (at a time after the old property is sold). Or the exchanger could bargain for and offer to pay a premium to the seller for an extended closing period.

In order for a second or vacation home to be deemed "qualified use" property for the purposes of Section 1031, the terms set by IRS are as follows:

For relinquished property, the home must be owned for at least 24 months immediately before the exchange and in each of the two 12-month periods in this qualifying period: (1)  the taxpayer rents the property to another person or persons at a fair rental for 14 days or more; and (2) the taxpayer's personal use of the property does not exceed the greater of 14 days or 10% of the number of days during each of the 12-month periods that the property is rented.

The test for the replacement property is similar to the test for the relinquished property: ownership of at least 24 months immediately after the exchange, two 12-month periods with 14 or more days of fair rental plus taxpayer use not to exceed the greater of 14 days or 10% of the number of days that the home is rented at fair value.

Some additional taxpayer use days may be allowed for repairs and annual maintenance, if well supported by documentation, receipts for expenditures, time logs, and the like.

Yes, you can sell your old property and take back a note & trust deed to help finance the sale. If the note & trust deed is made out to the exchanger the note is taxable.

However if the note & trust deed is made out in the name of the Qualified Intermediary (QI), you have choices on how to use it to buy replacement property:

1. You can use it to acquire replacement property by trading it to the seller for part of the equity in the new property. Use it as additional consideration.
2. You can instruct the QI to sell the note on the open market and add the amount realized to the exchange proceeds. This will give you all cash to negotiate your replacement purchase.
3. A party related to the exchanger such as a closely held corporation or relative may either purchase the note from the QI or provide financing so that the QI receives all cash at closing.

In general, IRS follows a “same taxpayer” rule. The same taxpayer who starts an exchange must be the one who takes title to the replacement property.

An individual or spouses in a community property state (i.e. California) may permissibly hold their property in an LLC at either end of an exchange. Such LLC's are “transparent entities” for tax purposes. Revocable or living trusts are likewise tax transparent: the grantors and trustees are typically the taxpayers' themselves.

But, irrevocable trusts are separate tax entities as are partnerships and corporations and such entities must start and complete 1031 transactions in their own name.

Yes. If taxpayer qualifies for the personal home exemption by having occupied the property for 24 months within the last five years, $250,000/$500,000 of cash may be excluded and any remaining gain is eligible for deferral under 1031 when either:

1. the property has been converted to rental (qualified use) property for an adequate holding period or
2. a home office has been claimed on prior tax returns enabling the home office portion of gain to be deferred and reinvested.

Limitation: The maximum Section 121 exclusion will be reduced, based upon the ratio of time that the primary residence had a non-qualified use (after 12/31/08) during the taxpayer's ownership that either preceded the home's use as a primary residence or occurred between periods of use as a primary residence.

Limitation: Section 121 requires that a residence acquired as a replacement property in a 1031 exchange must be held by the Exchanger for a total of five years before it will qualify for Section 121 capital gain exclusion on sale.

The investor should always consult with their own personal tax advisor whenever a change of use of a property occurs or is planned to determine with precision whether and to what extent Section 121 can be combined.

Yes. However, by IRS rule, once sale proceeds are deposited with the QI cash may only be used to acquire replacement property. To obtain cash, the investor may withdraw cash from the transaction from escrow prior to the closing of the relinquished property sale or after the 180 day exchange period has expired.

Because the investor is taxed on any proceeds being withdrawn from escrow or unspent and not applied to acquire replacement property, it is always wise to first determine what the capital gain tax would be had the property been sold outright.

Investors considering sale of investment or income property should always consult with their personal tax advisor to determine if a 1031 tax-deferred exchange will benefit their long-term investment and retirement goals.

In order to safely claim tax-deferral of 1031 proceeds attention must be paid to the items appearing on the estimated closing statement. Payment of the following transaction costs which typically show up on the closing statement are deemed "allowable exchange expenses" by IRS: real estate commissions, recording and escrow fees, title insurance, QI fees, transfer taxes, property & surveying inspections, legal fees related to the transaction and paid out of escrow.

Payment of the following expenses with exchange proceeds will result in the payment of tax and are considered "boot"; these costs should be paid with by a deposit to escrow using out-of-pocket funds by taxpayer: loan fees, loan points, prorated mortgage insurance, prorated property taxes and rents, property insurance premiums, and security deposits.

Be alert for other non-traditional, non-recurring items which may be inadvertently included on the closing statement; generally, any unusual items unrelated to the sale of qualified use property will be disallowed by IRS.

When seeking a tax benefit, you have to play by the government's rules!

The liabilities from which the seller/exchanger is relieved is treated as money received or “boot” and is usually taxable. However, if the taxpayer either adds additional cash (beyond exchange proceeds) or assumes mortgage debt to acquire replacement property, the amount of cash or new liability assumed will offset the amount of “boot” taxpayer is deemed to have received. This is known as the boot-netting rule. Don’t neglect to follow this rule when exchanging.

Taxpayers who move their exchange proceeds to another jurisdiction must file an annual report with the CA Franchise Tax Board to verify that such exchange property is still held.

If the taxpayer cashes out and no longer holds the replacement property, California will impose a tax on the California portion of gain realized. This is known as the “clawback” rule and is followed by a growing number of States, not just California.