Tax Deferred Exchage, What is this?

A tax deferred exchange is a straightforward method that a property owner employs in a property trade without having to pay the federal tax on the transaction. Generally in an ordinary sale transaction, the property owner is taxed on any gain he or she realizes by the sale of the property. But in exchange, this tax is deferred until some future time when the acquired property is sold. Authorized by the Section 1031 of the Internal Revenue Code, these tax rules are sometimes referred to as 1031 exchange rules. The transaction however must carefully meet the section 1031 rule set and must be structured in such a way that the transaction is in fact an exchange of one property for another and it is not a taxable property sale.

When you look at it, the tax deferred exchange is in fact an investment strategy that people are often not aware of. One of the misconceptions on the 1031 exchange rules is that an exchange requires 2 parties who want each other’s properties. However, in reality though, such two-party swaps rarely occur. Today, this exchange can be accomplished by involving four principal parties that include the exchanger, the seller of the replacement property, the buyer of the relinquished property and an intermediary. These parties often do not even know each other and may be located in different states. Furthermore, the exchange properties do not have to close at the same time. As long as the 180-day deadline has not been met, the exchange is considered legal and thus tax-free.

It is clear that 1031 exchange rules have the benefit of shielding the exchanger from incurring immediate tax liability. Upon the death of the taxpayer, the deferred tax is forgiven and the taxpayer’s estate never has to repay the ‘loan’. A tax deferred exchange nevertheless carries the disadvantage of additional fees for entering into the agreement. These costs could be attorney’s fees, accounting fees, intermediary and accommodation titleholder’s fees. The taxpayer is also not allowed to use the net proceeds from the property disposition other than in real property re-investment.