That 1031 exchange can seem confusing


December 28, 2003

A reader asks for examples of how a 1031 exchange works financially, and whether real estate agents' commissions can be deducted from the proceeds of the transaction.

Dear reader:

Section 1031 of the Internal Revenue Code authorizes tax-deferred exchanges of property.

Section 1031 exchanges are used most often for deferring taxes on the sale of investment real estate where all or part of the proceeds are used to purchase other investment real estate.

Taxes are deferred because the tax basis of the property sold - known as the relinquished property - is carried over to the newly purchased property - known as the replacement property.

To benefit from deferred taxes, the transaction must comply with the requirements of Section 1031 and IRS regulations.

Here's how a Section 1031 exchange typically works:

The proceeds from the relinquished property are not paid to the taxpayer.

Instead, the proceeds are held by a party unrelated to the taxpayer, known as a qualified intermediary, and pursuant to a written escrow agreement.

The taxpayer identifies potential replacement properties within 45 days after the transfer of the relinquished property by delivering a written document to the intermediary.

The taxpayer must settle on the replacement property within 180 days after the transfer of the relinquished property.

A taxpayer is allowed to do a partial 1031 exchange, in which case the portion of sale proceeds received by the taxpayer will be taxable.

It also is possible to do a "reverse exchange" under Section 1031. This procedure allows the taxpayer to purchase replacement property prior to the closing of the relinquished property.

A seller should not initiate a Section 1031 exchange transaction without checking with a tax adviser.

Real estate sales taxes are paid on gain, along with depreciation recapture, not the net amount received in the sale. A tax adviser can assist in computing potential gain and by making sure that the exchange transaction is properly documented.

It is possible for a taxpayer to have a big taxable gain and receive little cash proceeds from the sale. Taxpayers will maximize the benefits of a section 1031 tax-deferred exchange by:

Purchasing replacement property, which has a net sales price equal to or greater than the net sales price of the relinquished property. Real estate commissions and other closing costs are deducted in computing the net sales price.

Reinvesting all of the net sale proceeds in replacement property.

A contract of sale for relinquished property or replacement property should contain an agreement by both the buyer and seller to cooperate to handle a tax-deferred exchange.

The unrelated intermediary will supply other legal documents, including a contract assignment, escrow agreement and exchange instructions.

A Section 1031 exchange adds cost to the transaction. Qualified intermediaries charge fees for their services.

The taxpayer must report an exchange transaction to the IRS and state tax authority as part of his or her tax return.

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