When Does It Make Sense to Employ the 1031 Tax-deferred Exchange

Section 1031 of the U.S. Tax Code enables sellers to exchange an existing property (relinquished property) for a different property (replacement property), without incurring a "taxable event."

The first rule is that you must exchange "like-kind" properties, i.e., investment property for investment property (includes raw land) but you cannot exchange your principle residence for a new principle residence using 1031 provisions.

Second, once the relinquished property is sold (title changes hands), the replacement property must be identified within 45 calendar days (no exceptions) and the replacement property must be purchased within 180 calendar days (again no exceptions).

Third, the value, equity position and debt of the replacement property must be equal to or greater than the replenishment property.

Fourth, the sellers must employ a "qualified intermediary" to complete a 1031 transaction because sellers may not directly receive any proceeds of this transaction until it is completed.

Although sellers cannot enchange principle residences outright, they may occupy a replacement property as their principle residence after two years. After meeting the principle residency rules, the property could be sold, eliminating capital gains up to the limits and sellers would only pay the recapture tax (25 percent rate maximum) on any depreciation taken.

Any violation of these rules would result in a taxable event for sellers involving capital gains as well as recapture. So, you should consult with your accountant and an intermediary before proceeding.