In typical real estate transactions, the property owner is taxed on the gains realized from the sale. However, through a Section 1031 “Starker” Exchange, the tax on the gain is deferred until some future date.

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.

The reasoning behind the 1031 exchange is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that can generate funds to pay the tax. Put more simply, the taxpayer's investment is the same, but the form has changed and it would be unfair to force the taxpayer to pay taxes on paper gains.

The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

There are several flexible uses of the “1031 Starker” Exchange process. The Internal Revenue Code allows you to defer taxes when selling investment and business properties. Under certain guidelines, you can defer the capital gains tax to substantially increase your equity to re-invest into replacement property. The basic time frames for a delayed exchange are: 45 days to identify replacement property and 180 days to close on a like-kind property. There are no stipulations for extensions if a taxpayer does not meet the time requirements.

Lynx can help you achieve various investment objectives with this code:

Increase returns and leverage by trading from one to several replacement properties;

Investment diversification by exchanging to different property types;

Freedom from joint ownership by trading into separate properties;

Geographic relocation or consolidation by exchanging to different locations;
Decrease management responsibilities by exchanging into less management intensive properties and;

Increase cash flow and wealth building by trading high-equity properties to more productive properties.

There are several types of exchanges:

Simultaneous exchanges are the exchange of property that occurs at the same time.

Delayed exchanges (subject to the time limits listed previously) are the most common exchange.

Build-to-Suit (Improvement or construction) Exchanges allow taxpayers to build on or make improvements to the replacement property using proceeds from the exchange.

Reverse exchanges are referred to as parking arrangements and allow for the replacement property to be acquired prior to transferring the relinquished property.

Personal Property Exchanges allow for personal property to be exchanged for other personal property of like-kind or like-class. Property outside of the U.S. is not like-kind or like-class to property located in the U.S.

For a valid exchange to occur, the properties must qualify. Some types of property are excluded: property held for sale such as inventories, stock, bonds, notes, other securities or evidences of indebtedness; interests in a partnership: certificates of trusts or beneficial interest. If property is not specifically excluded, it can qualify.

Proper purpose clauses insist that the relinquished and replacement property must be held for productive use in a trade or business or for investment. Property is excluded that is acquired for immediate resale as is the taxpayers personal residence.

The exchange requirement requires the relinquished property be exchanged for the other property rather than proceeds from the sale being used to purchase the other property. Most exchanges are facilitated by qualified Intermediaries who are well versed in the intricacies of Section 1031.

Once the money is deposited into an exchange account, funds can only be withdrawn in accordance with the Regulations. The taxpayer cannot receive any money until the exchange is complete. If you want to receive a portion of the proceeds in cash, this must be done before the funds are deposited with the Qualified Intermediary.

The replacement property can eventually be converted to a vacation home or primary residence for the taxpayer, and even though there is no specific regulation governing the waiting period a one year period is generally considered safe by experts.
Once a closing occurs, it is too late to take advantage of Section 1031, but the exchange can be set up as long as the taxpayer has not transferred title, or the benefits and burdens of the relinquished property.

Potential replacement property must be identified in writing, signed by the taxpayer, and delivered to a party to the exchange who is not considered a "disqualified person". A "disqualified" person is any one who has a relationship with the taxpayer that is so close that the person is presumed to be under the control of the taxpayer. Examples include blood relatives, and any person who is or has been the taxpayer’s attorney, accountant, investment banker or real estate agent within the two years prior to the closing of the relinquished property. The identification cannot be made orally.

There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these rules: 3-Property Rule: The taxpayer may identify up to 3 potential replacement properties, without regard to their value; The 200% Rule. Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished
property, or; The 95% Rule. The taxpayer may identify as many properties as he wants, but before the end of the exchange period the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.

Other terms to be familiar with are:
Realized gain. The increase in the taxpayer's economic position as a result of the exchange. In a sale, tax is paid on the realized gain.
Recognized gain. The taxable gain. Recognized gain is the lesser of realized gain or the net boot received.

For more information, contact a Lynx representative at (404) 477-2044 or email info@lynxre.com