So how is it done?   Well, actually, it’s a "very simple process" if you follow the rules properly.   This is a powerful tool that the Federal Government has provided we the Taxpayers.   Basically, if you own investment real estate (i.e. condo, single family house, townhouse, office building, land, etc. - which is held as investment property), then your property would likely qualify for a tax deferred exchange.   There is no limitation placed upon you based on your taxable income, age, number of times you have previously sold properties utilizing the tax deferred exchange, etc.   You begin "the process" by placing your property on the market for sale - be sure to note in the listing agreement that you intend to sell your property subject to an IRS 1031 Tax Deferred Exchange. This language must also (especially) be in your sales contract with your eventual Buyer.

Once your property (that you are selling) is placed "under contract", if you haven't already, you should begin the process of locating the next property you want to purchase.   The law allows you "45 days from the date of settlement of the property you are selling" in which to "identify" the replacement property (the one you will be purchasing).   Now, "identify" means just what it says.  Section 1031 permits a Seller to identify up to 3 properties without any purchase price limitations.  If a Seller identifies 4 or more properties, the total combined purchase price can not exceed twice the price of the property being sold.  (This is known as the 200% Rule.)  Make sure you identify them according to IRS rules (talk with your tax advisor as to how this needs to be done).   The way most people do this is by entering into a sales contract to purchase a particular property - the sales contract itself serves as proof of "identification".   Again, be sure that the language regarding the tax-deferred exchange is in the purchase contract as well.

NOTE:   I have specific language for this type of transaction - please contact me with any questions regarding this in particular.

Now, once you have "identified" the property(s)  you intend to purchase by virtue of a sales contract, then you have everything in motion.   The timeline in which you must close on the property you are purchasing is as follows: "180 days from the date of the settlement of the property you 'sold', inclusive of the first 45 day identification period".

It is really just this easy!   The main issue that you must know is that you may not take possession of the funds from the settlement on the property you "sold."   If you do, then the IRS will take the position that you are in receipt of the gain, and you will be required to pay the Capital Gain tax.    To avoid this costly error, you must advise your real estate settlement attorney, at time of contract on property you are selling, of your intention to take advantage of the "deferred exchange."   Your closing attorney, at settlement, will arrange for a "third party" qualified Intermediary company to "hold your funds in escrow" -  to be released directly back to your attorney at the time of settlement for the property you purchased.   This way you never come into receipt of the monies.   This service is an expense and can range from $500 to $2,000 or more depending on the amount escrowed and the duration the funds are held.

NOTE:  There are circumstances where if the Property you are “Selling” is sold for an amount “HIGHER” than the Property you are “Purchasing” as it’s replacement … you may still take advantage of the 1031 Exchange on  PARTIAL BASIS!  You  can defer a “Partial Amount of Gain”, and therefore pay capital gain tax on the remaining Portion.  This is not overly complicated, and can be easily computed by your tax advisor.  The advantage here is that you have some flexibility and are not forced to pay all of the gain just because the replacement property sales price is less!

You can exchange "Like-Kind" properties only.   What do I mean by this?   For example, you can exchange a rental house for an office building, an apartment building for two unimproved lots or a warehouse.  You also can exchange one property for several or several properties for one.

One of the most significant developments over the past few years involving tax deferred exchanges is the 1031 REVERSE EXCHANGE.
In a reverse exchange, a third party called the Exchange Accommodation Titleholder (EAT) acquires title to the replacement property first, and holds it until the Seller is able sell their old property.  As in normal 1031 exchanges, the EAT must convey title within 180 calendar days from the date of the EAT's purchase. 
The reverse exchange allows investors to acquire desirable replacement property before selling their old property, relieving some of the pressure associated with finding a suitable replacement property within the 45 day identification period.  The reverse exchange regulations permit the making of suitable improvements or even building from the ground up (as long as the property is in the EAT's name) before the relinquished property is sold with the cost of the improvements or construction paid for during the 180 day exchange period.  These cost are considered in the exchange calculation.
To facilitate reverse exchanges, investors may loan money to the EAT, guarantee a bank loan to purchase the new property, lease the new property from the EAT during the holding period, lease the property to others, manage the property, supervise improvements, act as a contractor, and provide other property related services to the EAT.

In October 2004, President Bush signed into Law H.R. 4520, the American Jobs Creation Act of 2004.  This legislation includes language to Section 121(d) of the Internal Revenue Code.
“(d) (10). PROPERTY ACQUIRED IN A LIKE-KIND EXCHANGE.  If a taxpayer acquired a property in an exchange to which Section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the 5 year period beginning with the date of the acquisition of such property.”

… So, what does this mean to you? 

Basically, after a taxpayer converts a replacement property that was received in an IRS 1031 Like-Kind Exchange to their principal residence, they must own the property for 5 years before they can sell the property and claim the principal residence $250,000 or $500,000 exclusion of gain on the sale.  They still must have “used the property as their principal residence for 2 of the past 5 years”.  This 5 year ownership restriction applies to all replacement property sales after October 21, 2004.

The benefits of the tax-deferred exchange are numerous ... Mainly, it allows you to defer payment of the capital gain tax upon the sale of your investment real estate to the next investment property.   You could actually, if tax laws stay the same, continue to sell/purchase your investment real estate utilizing the tax deferral again and again - Buying Bigger and Better rental properties! The basis of the first property can be carried forward to the next property over and over again!   The consensus is that the ($) Dollar will be worth less in the future than it is today, and eventually, upon retirement, your tax bracket may be lower than it is today - these two things combined make planning when to pay (and you will end up eventually paying) the Capital Gain.

Currently, the rates for the Capital Gain are as follows:

Keep in mind that this is available to you all over the United States!   This is a Federal Law, not a North Carolina State Law.    I have had Clients sell an Investment here, and Buy another Investment property in another State.   I have had many Clients sell a property they owned here at the beach, and then purchase a larger, newer home - often, closer to the beach.    I spoke with a potential Buyer Client just recently - she and her husband own a mountain rental property which they will be selling - this exchange may just be the way for them to go.   Out of all the transactions which I handle each year, less than 25% actually utilize the exchange.   For many, it is not an advantage for one reason or another.   But, for those who can take advantage of it, it is a great way to go!

SANDMAN Team OBX