Exchange evolution: 1031 Exchange Refreshed and Revisited.

AuthorKoehler, David
PositionRealestatetaxes

many investors are faced with major tax consequences when selling real estate. One of the most taxpayer friendly Internal Revenue Code sections is See, 1031, which allows taxpayers to fully defer paying any taxes on a properly executed exchange of real property. As the economy stabilizes and real estate values trend upward, the real estate industry again is seeing an upswing in tax deferred 1031 exchanges.

Before advising your clients on whether to exchange, hold or sell a property and pay the taxes, a review of the history, mechanics, pitfalls and lessons of the past is warranted.

The initial IRC Sec, 1031 allowed taxpayers to execute a simultaneous exchange of real properly and defer taxes by lowering the basis of the replacement property by the amount of die realized gains of the initial sale. The 1979 Starker case dramatically broadened the definition of exchanges by allowing deferred exchanges.

There are strict guidelines, such as identifying the replacement properly or properties within 45 days, replacing property within 180 days and using an exchange accommodator, to follow to qualify for non-recognition of gain.

To defer gains, the taxpayer must not lake any cash or equity out of the transaction and maintain similar or higher overall mortgage debt. The motivation to exchange is generally to seize a market opportunity on the sale, leverage built-up equity into a larger purchase, create diversity of holdings or improve overall cash How through better economies of scale and often times more leverage.

Due mainly to the strict timing rules on finding and closing a replacement transaction, 1031 exchanges were generally stressful for taxpayers and. many times, failed. Similarly, some investors would let the "tax tail wag the economic dog" and force a bad purchase solely to chase a deferral of taxes.

With hindsight, many investors realized what a poor real estate purchase they made.

Real estate transactions carry a buyer-beware element and often, in the haste to close an exchange, rushed decisions get made on selecting, understanding and purchasing the replacement properly or properties. Your clients should think through the necessity, goals and expected outcomes of an exchange before embarking on the process. Due diligence on real estate purchases needs to be done upfront.

A major evolution in 1031 exchanges occurred in 2002 when the IRS issued Revenue Ruling 2002-22, which allowed for replacement properties to be held in a tenant in...

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