A properly structured 1031 like-kind exchange allows the investor taxpayer to relinquish old investment property and acquire replacement property without recognizing and paying the taxable capital gain tax that would normally be due.

Instead of paying capital gains taxes on the sale, the taxpayer acquires new property with its basis reduced in an amount corresponding to the gain he deferred. By deferring this tax, exchangers retain 100% of their equity to reinvest, providing more buying power and opportunities.

1031 exchanges are defined by section 1031 of the Internal Revenue Code. The code provides that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business or for investment purposes. Section 1031 of the federal tax code provides a method of structuring a sale of qualifying property followed by a purchase of "like-kind" property as a tax-deferred or like-kind exchange.

For property to be eligible as either relinquished property or replacement property in a 1031 exchange, it must be held by the exchanger for productive use in a trade or business or for investment purposes. If structured in advance with a Qualified Intermediary, the taxpayer has 45 days after the relinquished property closing to identify replacement property, and 180 days to actually close on the replacement property.

For illustration purposes, assume that a taxpayer acquired raw land fifteen years ago that he now intends to sell for $500,000.00. The property is debt-free and the original purchase price of that property was $200,000.00. He wants to use the sales proceeds from the land to acquire a new office building for $650,000.00. If structured as a sale rather than an exchange, he would pay state and federal capital gains taxes of at least $80,000.00 that could have been avoided. After taxes, he would have $420,000.00 equity to invest in new property, borrowing the additional $230,000.00. If, however, he structured a like-kind exchange, he would transfer the old property for $500,000.00 and the entire $500,000.00 equity would be used towards equity in the new property, reducing his loan to $150,000.00. The tax-deferral is almost like an interest-free loan from the government.

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How do I plan for an exchange?

To properly structure an exchange, a taxpayer should seek expert tax advice from a knowledgeable tax or real estate attorney. He may also want to consult his CPA to discuss tax and basis calculations and reporting requirements. Your Buyer's Agent, Mark Wilson, will keep you organized and facilitate your transactions. Choosing a competent, experienced Qualified Intermediary company is another essential ingredient for a successful exchange. As the taxpayer's exchange partner, the Qualified Intermediary must hold the taxpayer's sales proceeds for the purchase of the replacement property. If the taxpayer is in constructive receipt of those sales proceeds, his exchange will fail. The experienced Qualified Intermediary will understand the tax code restrictions to help prevent the taxpayer's constructive receipt of exchange funds. Other important considerations when choosing a Qualified Intermediary include whether or not they provide fidelity bonding, offer interest on the exchange proceeds, offer document preparation, deadline reminders, and a paper-trail for accounting or audit purposes.

Besides saving taxes, what other financial planning reasons motivate an exchange?

Change the type of property owned. As illustrated above, a taxpayer may want to change the kind of real property he owns. The definition of "like-kind" is a common exchange misconception. In real property exchanges, any real property used for business or investment is "like-kind" to any other real property that is also used for business or investment. But, the business or investment use of the property need not be identical. For example, this enables a taxpayer who owns raw land to take advantage of a tax-deferred exchange, trading it for income-producing rental property. Or, a taxpayer may want to exchange residential rental property for more lucrative office or retail rental property.

Change the property's location. Many taxpayers structure an exchange to physically move their qualifying property. Structuring an exchange would enable a taxpayer to move his office to a more suitable location without immediate tax consequences. Or, if a taxpayer moves geographically from one city or state to another, he could also relocate his qualifying investment or business real property without triggering recognition of the capital gain in the property he relinquishes. This technique is particularly useful for owners of rental property who move to another geographic area and want the ease of managing local property.

Leverage. Some taxpayers use tax-deferred exchanges to leverage their equity in one property, buying multiple replacement properties. For example, a real estate investor began several years ago with one rental house. After a few years, she exchanged that house for three rental houses, tripling her rental income. Subsequent exchanges have substantially increased her portfolio of investment properties.

Retirement planning. A common strategy used among taxpayers planning for retirement is to exchange business or investment property for qualifying rental property. After a few years of qualifying use, the taxpayer may be able to convert the rental property to personal use as a retirement home. If used thereafter as a primary residence, the taxpayer may ultimately be able to exclude the recognition of gain under the capital gain exclusion for the sale of primary residences.

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This information courtesy of Investors Title Exchange, one of the better sources for 1031 exchange information and 1031 transaction assistance for Raleigh, Cary, Apex, Wake Forest, Research Triangle, Wake County, North Carolina. Click here for guidelines.