The Power of a 1031 Exchange

By: David Stevens

If you are thinking of selling a business or investment property, Internal Revenue Code 1031 is an important option to consider. This IRS code is most often called a 1031 Exchange, but is also known as a deferred exchange, Starker exchange (named for the Starker Case which changed the nature of the Code in the 1970's), real property exchange or like-kind exchange.

No matter what you call it, exchanging offers a real estate investor the opportunity to reinvest federal capital gains normally paid to the IRS. Code 1031 provides that no gain or loss will be recognized on the exchange of any type of business use or investment property for any other business use or investment property.

What does all this mean? Since an exchange provides a deferral of the taxes due on the sale, an investor can increase his selling and buying power. With extra money available, he or she achieves increased buying power and enjoys an improved profile when it comes to acquiring the necessary financing.

Take a look around the local market - you've surely noticed the recent proliferation of Walgreen and Eckerd drug stores and may have wondered how they can pop up so fast. Developers are well aware of the power of exchanges. With foresight they purchase and develop land with 1031 investors in mind. In fact, more than 90 percent of these properties have been bought by 1031 investors with their "tax advantaged" funds.

More Than a Swap

Contrary to its name, exchanges aren't typically an old-fashioned, two-party "swap." A 1031 Exchange simply requires that a seller must purchase a property of similar use or service. To the advantage of the investor, "similar use or service" is a broad term. Real property held for business use or investment can be exchanged for real property held for business use or investment. It's a simple as that.

This opens many doors, the most obvious being the ability to purchase a replacement property with greater immediate income potential. For instance, an investor can sell raw land and acquire a shopping plaza. He or she also can do the reverse and purchase a replacement property with more long-term investment value by selling a warehouse and acquiring raw land. If an investor desires a change in relationship with a property, an 1031 Exchange can also accomplish this goal. For example, an apartment complex could be exchanged for a less management-intense property.

IRS Code 1031 Exchanges are not limited to a two-property transaction, either. With the extra funds an exchange makes available, it is possible to sell one property and acquire three or four, or sell four and acquire one. As long as all the properties involved are like-kind real property, the number of properties sold or purchased is unlimited.

The question often arises: once the relinquished property is sold but the exchange property has not yet been purchased, who holds the funds in the meantime? The IRS realized that an unscrupulous investor might get a few bright ideas. Code 1031 therefore requires the use of a qualified intermediary. This independent third party - typically an attorney or title company -keeps the money out of investors' hands while the exchange property is being identified and the sale closes.

The History of Exchanges

Originating in the 1920's, 1031 Exchanges have evolved significantly over the years. In 1935, the concept of multiple-party exchanges was first introduced. In the 70's, after the famous Starker Case significantly shaped the future of exchanges, simultaneous exchanges were born. "Starker Exchanges" were codified in 1984. Finally, in 1991, the IRS issued safe harbor regulations and made 1031 regulations easier than ever.

While Code 1031 has been simplified over the years to the advantage of investors, there is, of course, the IRS' share of fine print. For instance, investors must adhere to time limitations. A 45- day identification period begins at the closing of the relinquished property and requires the identification of the like-kind replacement property. There is also a 180-day exchange period, which runs concurrently with the identification period and requires the acquisition of at least one of the identified replacement properties.

Seek Expert Advice

As with any investment, but particularly with one involving an IRS Code, it is important to consult with a trusted accountant. The proper documentation must be used in order to comply with 1031 regulations, and there are a number of rules that must be followed. And with some of the rules, there are also exceptions. An accountant will be able to analyze your situation and advise you accordingly. Competent legal advice might also be required.

The 1031 Exchange is an extremely wise choice for many investors. Used properly and with prudence, a pyramid effect is possible. In a relatively short span of time, a number of properties can be exchanged. The net, cumulative effect is the rapid multiplication of the number of properties owned, or the acquisition of fewer properties with greater value.

David Stevens is a principal with Grubb & Ells|IPC, a full-service commercial real estate company serving Southwest Florida.