1031 exchange also called 1031 exchange properties, property exchange, 1031 deferred exchange, or tax-deferred exchange can be found under Section 1031 of the Internal Revenue Code. It states that the taxpayer can replace his or her property with the replacement purchase of a like-kind property on a tax-deferred basis.
For example, a homeowner (or taxpayer) that is interested in selling his or her home to purchase a similar home up the street can use the exchange rule if the target house or house to be purchased meets the criteria of a 1031 exchange, meaning target house is a like property (single-family residential, in this case) and the value (after performing a CMA and appraisal) of both houses are the same, e.g., both houses are worth $300,000.
Many people think that most 1031 exchanges are the result of a homeowner who enters into a "meeting of the minds" or Exchange Agreement with another homeowner to exchange deeds without a professional intermediary. Although this is acceptable and legal, it is not the rule. In most 1031 transactions, the seller of the replacement property does not buy the other's relinquished property.
The basic types of 1031 exchanges include:
Simultaneous exchange - both replacement and relinquished properties close on the same day
Delayed exchange - the replacement property is closed on a later date than is the relinquished property
Reverse exchange (title exchange) - the taxpayer purchases and closes on the replacement property before selling his relinquished property. The intermediary or title company takes title of the replacement property under the Exchange Agreement until the taxpayer's relinquished property is sold. Once the relinquished property is sold, the intermediary confers title to the taxpayer of the replacement property.
Improvement exchange (another title exchange) - the taxpayer desires a replacement property, but needs to make improvements on the replacement property to satisfy the exchange of the replacement property. In the Exchange Agreement, the intermediary takes title to the replacement property until the improvements on the replacement property have been made. Once the improvements are made and the Exchange Agreement has been satisfied, the intermediary conveys title to the taxpayer of the replacement property.
Before listing examples of 1031 exchanges, let's define the term "boot." A boot is taxable money paid to a taxpayer from an exchange in which the value of the replacement property lags the value of the relinquished value and vice versa. A true 1031 exchange is not only the purchase of like-kind but also like-value properties. To take full advantage of 1031 exchange benefits, the taxpayer should never "trade down" for a replacement property. The taxpayer should always hold to the 1031 maxim: replace property with a property of equal or greater value.
Again, the replacement property must be like-kind. For example, a single-family residence can be replaced by another single-family residence but not income property such as a rental or business building. Conversely, a duplex can be replaced by a four-plex but not by a single-family residence or business building.
The main benefit of participating in 1031 exchange properties allows the taxpayer to sell investment, business, or income property and purchase like-kind replacement property without having to pay taxes to the federal government.
The disadvantage of 1031 exchange properties is since the replacement property has a reduced rate for depreciation, the replacement property's deferred gain is taxable at some future date when the taxpayer decides to sell the replacement property.
To find out more, taxpayers can enlist the services of a public accountant, tax advisor, attorney, realtor, or title representative to have a 1031 explained to them.