By Karen Hurd

For over fifty years, astute real estate investors have been taking advantage of 1031 tax deferred exchanges - a little-known but powerful tool for preserving real estate wealth. The history of tax-free exchanges dates back to the 1920's. These early exchanges involved two parties who traded or swapped properties.

Given the tax advantages and simplicity, it's surprising few real estate professionals use 1031 exchanges - or are knowledgeable about them. If you've wondered about 1031 exchanges, and how to use them - the five most commonly asked questions below will help explain the basics.

Question #1: What is a 1031 Exchange?

Under Section 1031 of the Internal Revenue Code, capital gains taxes on investment properties may be deferred when certain types of property are exchanged. The law enables a property owner to exchange one property for another of like kind and defer paying federal (and most state) income taxes on the transaction. A strict set of rules governs 1031 exchanges.

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For example, suppose you buy a $400,000 property, hold it for 5 years, during which you invest $150,000 of improvements and deduct $50,000 in depreciation and then sell it for $1,000,000. You would have a $500,000 capital gain, leaving you with a hefty $80,000 Federal tax bill.

By selling your property and buying another of like kind within the specified exchange period, you can defer this tax using a 1031 Exchange.

Question #2: How Do Transactions Qualify as 1031s?

In order to qualify as a 1031 exchange, your transaction must meet the following criteria:

• Qualified Use - The old property must be held for productive use in a trade or business or "held for investment" - for example, a car wash, an automotive business, a multi-family property that's rented out, a commercial building or warehouse. The new property must also be intended for use in trade or business or "held for investment". Your principal residence, other personal use properties such as a vacation home (with certain exceptions) and properties "held primarily for sale" (i.e.: properties that you intend to resell) do not qualify.

• Like-Kind - The new replacement property must be like kind to the old relinquished property. The like kind standard for real estate is very broad. As long as the properties are investment or business properties, use does not matter. For example, an office building can be exchanged for a retail shopping center, or a retail shopping center for unimproved land. If improved property is exchanged for unimproved property there are other non-1031 tax issues to consider. Properties also do not have to be in the same state - you can do a 1031 exchange with a property in Texas and one in Massachusetts. However many states have non-resident withholding rules. Section 1031 exchanges are frequently an exception to the state's withholding requirements.

• Value Rules - To fully defer all the capital gains tax, you must reinvest all of the equity (net proceeds) from the sale of the old property into the new property, and. the value of the new property must be equal to or greater than the value of the old property. There are two common misconceptions: One is that if there are no proceeds, there's no tax gain. That's not true. It's possible that fully encumbered property has a tax gain that can be deferred. Two, another misconception is that you only need to reinvest your net equity in replacement property. That's also not true. You must acquire a replacement property at least equal in value to the property you are selling to fully defer the gain. There may still be a tax benefit to doing a partial exchange in which a property of lesser value is acquired.

• Time Restrictions - The transaction must comply with two deadlines: A 45-day identification deadline to list the properties you are considering purchasing, and a 180-day deadline to close on the purchase of one or more of the properties from your list. Both deadlines are measured from the date the old property is sold. There are no exceptions to these deadlines. You should also note these are "calendar day" deadlines - not "business day" deadlines. The 45-day deadline is the most significant not only because it expires so quickly, but also because you may only identify three potential replacement properties. Alternatively, you can identify more than three if the value of all the replacement properties you list is less than double the value of the property you sold.

• Qualified Intermediary - You must secure the assistance of a Qualified Intermediary ("QI") to prepare the legal documents for your exchange and to hold your money during the course of the transaction. The Intermediary can't be your relative, attorney, accountant, stockbroker, or another business associate. There are new IRS rules governing how a QI must set up an account holding your exchange funds.

• Identity of the Taxpayer - The new property must be held by the same person or business entity as the old property. You cannot not sell a property owned by John Smith and exchange it for a property owned by Smith Enterprises, Inc. for example. However, if the entity is Smith Enterprises LLC owned solely by John Smith, that would be OK because the IRS does not consider a single owner LLC as a separate entity for tax purposes.

Question #3: What kind of paperwork will I need to fill out?

The documents in a 1031 exchange must be completed in strict accordance with the IRS code and regulations. It is important you engage the services of a professional, experienced Qualified Intermediary who will complete the documentation, including the exchange agreement, assignment of rights and a notice of assignment, for you. To accurately prepare your exchange documents, the QI should review your property sale contract, how you hold title to the property being sold, and how you have filed your taxes.

Question #4: Why do I need a Qualified Intermediary?

In a nutshell, because the IRS says so. The IRS regulations contain "safe harbors" you must follow for your transaction to be considered a 1031 exchange. The main safe harbor is the "qualified intermediary" or "QI" safe harbor. The QI is an independent entity that you transfer your old property to, which holds the sale proceeds and uses the proceeds to acquire the replacement property and transfer the replacement property to you. You must enter into a written exchange agreement with the QI, and the agreement must describe how the QI will satisfy the property receipt and transfer requirements, and how the funds will be held, invested and distributed.

Under the Regulations, you may directly enter into contracts with the buyer of your old property and the seller of the replacement property, and then "assign" these contracts to the QI. You must also give notice of the QI assignment to the other contract parties before the property transfer. This is simpler than the old practice which required actually deeding the properties to the QI.

The main requirement in the QI safe harbor is that you cannot have actual receipt or "constructive receipt" of the funds before the end of the exchange. After you start the exchange, the QI can release funds only to acquire identified replacement property. However, if you do not identify, you can receive the funds on the 46th day. If you identify property but do not use the funds to acquire identified property, you must wait until the end of the 180 days to receive the funds. Any improper receipt of funds will cause the transaction to be a taxable sale.

Question #5: What else do I need to know to make sure my 1031 exchange is transacted smoothly?

A number of other details to consider include:

• You, as the taxpayer, cannot have actual or constructive receipt of the proceeds of the sale of the old property except to acquire replacement property. Your QI should look at your settlement statement to make sure that you are not inadvertently being taxed. For example, if you use sale proceeds to reimburse the buyer for rents you have received, that use of the sale proceeds is taxable. Also, if you anticipate needing some of the proceeds for another purpose, you should advise your QI so that you can receive funds from the closing agent, because you will be unable to have the QI distribute the funds to you. However, you will be taxed on the funds you receive.

• You can't set up an exchange after you sell the old property. You must enter into an exchange agreement with a QI, establish the appropriate exchange account and have the sale contract assigned to the QI and give written notices to all parties BEFORE the sale takes place.

• Look early for your replacement property. Anyone who has done an exchange realizes that the 45-day identification deadline is the most difficult challenge.

• To fully defer tax on capital gains, the you must buy a replacement property of equal or greater value than the old property, and you must use all the proceeds from the sale. If you buy a replacement property of lesser value, or don't use all the proceeds, the difference will be subject to tax. This is known as a "partial exchange."

• Make sure that when you are applying for financing on your replacement property that you do not borrow so much that you are unable to reinvest all of your proceeds from the old property.

Although they sound complicated, 1031 exchanges are a great way to defer taxes on investment properties. To ensure your 1031 exchange goes through without a hitch, carefully research and choose your Qualified Intermediary and meet your deadlines. You'll find the entire process is quick, painless, and advantageous to your bottom line.

Karen Hurd is an Assistant Vice President with Compass Exchange Advisors, LLC, a Qualified Intermediary based in Plymouth, Massachusetts. Compass (www.compass1031.com) is a subsidiary of Rockland Trust Company. Rockland Trust was founded in 1907 and is the largest publicly traded commercial bank headquartered in Massachusetts. Rockland Trust is a wholly-owned subsidiary of Independent Bank Corp. (NASDAQ:INDB) with approximately 3.4 Billion in Assets. You can contact Karen via email at Karen.hurd@rocklandtrust.com or by phone at 781.831.8842.

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