1031 Exchange

The US Internal Revenue Service (IRS) income tax law code section 1031 Exchange provides deferment of capital gains tax on certain exchanges of well-defined investment properties. The section requires that the exchange must be completed within a stipulated time limit if the tax payer is to benefit from the deferment of capital gains tax.

When a tax payer sells a property normally for cash, he is required to pay capital gains tax on the profits realized from the transaction.

The clauses under IRS code section 1031 Exchange provide that if the taxpayer sells a certain property not for cash profit, but to acquire other similar property, it is construed that no loss or gain has accrued to the taxpayer. In such a case, the taxpayer is allowed to defer the capital gains tax until the time the replacement property is sold for cash profits.

The benefit from such a transaction is that an investor/taxpayer can replace one property with another like property, which has the potential for more profit in future. This would provide him/her benefits at a later date. Further, it is not necessary that a taxpayer stop after completing one such transaction. He/she can later sell the replacement property in exchange for another like property (that has even more profit potential) again without any cash profits. This second transaction would again defer the capital gains tax.

The IRS has provided for the role of a third party known as a Qualified Intermediary for the transactions of such like properties.

The Qualified Intermediary would acquire the relinquished property from the taxpayer (known as Exchanger) through an Exchange Agreement and sell it to the buyer by direct deed from the Exchanger. The buyer would transfer the transaction money to the Intermediary. The latter would then use the Exchange Funds to buy the like replacement property for the Exchanger. Any net cash proceeds of the transactions would stay in the hands of the Intermediary.

Important stipulations for the 1031 like-kind exchanges to enable a tax payer to obtain capital gains tax deferment benefits are as given below. In case any of the conditions are violated, the taxpayer will be required to pay capital gains tax on the transaction.

Stock or bond transactions are not covered under 1031 Exchange. A limited period of 45 days is available to the Exchanger from the date of the relinquished property transaction for identification of the replacement property. A written notification must be received by the Intermediary from the Exchanger within the above stipulated period. In the notification the names and address details of any potential replacement properties must be provided.

Further, the purchase of the replacement property must be completed within 180 days from the date of transaction of the relinquished property of the Exchanger. No changes in the so identified potential replacement properties can be effected by the Exchanger after the set 45 days limit. The Exchanger is bound by 1031 Exchange to purchase one of the identified replacement properties.

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