These exchanges are known by several names, including like-kind exchanges and the more frequently used Starker exchanges. The beauty of using Section 1031 is that it permits the taxpayer to avoid capital gains tax on the increase in value of the property being exchanged.
Real estate tax-deferred exchanges have been allowed under the Internal Revenue Code since the 1920s. However, it wasn't until the Starker v. United States lawsuit in 1979 that taxpayers could do a nonsimultaneous exchange of real estate. The only problem was that the Internal Revenue Service had not prescribed any rules or regulations advising taxpayers on how to proceed with Starker exchanges.
Recognizing the problem, the IRS issued final regulations providing codified provisions on how to do exchanges in 1991, and nine years later, issued Revenue Procedure 2000-37, which recognizes the use of "reverse" like-kind exchanges. Up until then, the IRS rules pertained only to "forward" exchanges, or exchanges in which the old or relinquished property was sold by the taxpayer, who then acquired the new or replacement property.
So how does the taxpayer actually do an exchange? In doing a forward exchange:
* The taxpayer first sells his old or relinquished property.
* The taxpayer then identifies new or replacement property within 45 days of the sale of the old property and, generally speaking, closes on the purchase of the new property within 180 days of the sale of the old property.
A qualified intermediary then holds the proceeds from the sale of the relinquished property until directed by the taxpayer to pay out the proceeds to acquire the replacement property. In effect, the taxpayer never receives the relinquished property sale proceeds but rather rolls the proceeds into the purchase of like-kind replacement property.
By doing this, the taxpayer can defer the capital gains tax because the taxpayer theoretically never received cash and consequently is not required to pay a tax. If later on the taxpayer decided to sell the new property and again does an exchange, the capital gains tax would again be deferred.
The taxpayer can do as many exchanges as he or she wishes, without ever paying a capital gains tax. When the taxpayer dies, the property receives a "stepped up" cost basis and capital gains have never been taxed.
A reverse exchange produces the same results. In a reverse exchange, the taxpayer acquires the new or replacement property before the old or relinquished property is sold. This situation arises when the seller of the new property tells the taxpayer that he or she must buy the replacement property right away or lose it. The reverse exchange operates within the same 45- and 180-day guidelines as the forward exchange and, again, the taxpayer theoretically never receives any cash.
One of the advantages of using Section 1031 is that although the taxpayer is supposed to exchange real estate for like-kind real estate, any real estate located in the United States is considered like all other United States real estate. That means that a farm in Wisconsin can be exchanged for a shopping center in Illinois.
Note, however, that Section 1031 only applies to property held by the taxpayer for productive use in a trade or business, or property being held for investment. So if you want to exchange your personal residence for your neighbor's house across the street, a 1031 exchange won't work.
Finally, a 1031 exchange can also be used to exchange personal property such as airplanes, railroad equipment, computer equipment, boats, trucks, cars and agricultural equipment. Unlike real estate, however, like-kind is interpreted much more narrowly. That is, a boat must be exchanged for a boat, etc.
Be sure to work with your attorney to realize the tax advantage available under Section 1031. Richard S. Witek, JD, is vice president, Trust Administration, at MB Financial. Reach him at (312) 633-0333 or through the company's Web site, www.mbfinancial.com.