SECTION 1031 EXCHANGES WHAT YOU NEED TO KNOW

“Because of the complex nature of the Section 1031 Exchange rules you should always consult with an experienced Pennsylvania real estate attorney if you plan to pursue an exchange; however,

gaining a basic understanding of the Section 1031 Exchange process is a good place to start.”

Charles Curley Pennsylvania Real Estate Attorney

Section 1031 Exchanges: What You Need To Know curleyrothman.com 2

Over the course of your lifetime

you will likely buy and sell a

significant number of assets.

Ideally, you will make a profit off

the sale of those assets. As you

are undoubtedly already aware,

the United States federal

government typically wants its

share of income you earn as

well as profit you realize when

you sell an asset. One way to potentially defer – indefinitely – the taxes you owe

on the gain realized after the sale of a capital asset is to enter into a Section

1031 Exchange in lieu of a traditional sale. Because of the complex nature of the

Section 1031 Exchange rules you should always consult with an experienced

Pennsylvania real estate attorney if you plan to pursue an exchange; however,

gaining a basic understanding of the Section 1031 Exchange process is a good

place to start.

Capital Gains Taxes

When you sell a capital asset in the United States you may incur capital gains

taxes on the gain realized from the sale of the asset. According to the Internal

Revenue Service, or IRS, capital assets include almost everything you use for

personal or investment purposes, including your home, your household

furnishing, collectibles, and stocks and bonds held in a personal account. Gains

(and losses) are divided into short-term and long-term. From a policy perspective

Section 1031 Exchanges: What You Need To Know curleyrothman.com 3

the IRS would prefer that you hold on to assets so long-term gains are typically

taxed at the lower tax rate of 15 percent.

What Is a Section 1031 Exchange?

One way to avoid paying capital

gains taxes, at least in the short-

run, is to enter into a Section 1031

Exchange (named for its location

in the U.S. Code -- 26 U.S. Code

§ 1031) instead of a traditional

sale when you “sell” certain types

of capital gains assets. Also

referred to as a “like-kind

exchange”, a Section 1031

transaction effectively allows you

to swap one asset for another.

When a transaction qualifies for

Section 1031 treatment any

capital gains taxes that would

otherwise be due are deferred.

What Are the Benefits to a 1031 Exchange?

For anyone who has significant business or investment assets it can become

costly to buy and sell those assets if you have to pay capital gains taxes on every

Section 1031 Exchanges: What You Need To Know curleyrothman.com 4

sale. Much of the profit from the sale is lost to capital gains taxes. Using a 1031

Exchange, however, allows you to defer most, or all, of those taxes. Because

there is no limit to the number of times you can enter into a Section 1031

Exchange you can keep swapping one asset for another indefinitely, ideally

increasing the value of the asset each time and allowing your investment to grow

tax-deferred.

When Is a Transaction Eligible for Section 1031 Treatment?

There are certain eligibility requirements for a transaction to qualify as a Section

1031 Exchange, including:

The property must be held for productive use in a trade or business, or for

investment

The property must be exchanged for “like-kind” property

The entire exchange must be completed within 180 days

A Qualified Intermediary, or QI, must be used to facilitate the exchange

Can I Use a 1031 Exchange When I Sell My House?

Only assets “held for productive use in a trade or business, or for investment”

qualify to be used in a Section 1031 Exchange. It is possible to do a 1031

Exchange with a vacation property; however, only when specific conditions are

met, including:

Both the relinquished property and the replacement property must be held

for a period of at least two years.

During each of the two year periods the property in question must have

been rented for at least 14 days or more at fair market value.

Section 1031 Exchanges: What You Need To Know curleyrothman.com 5

What Does “Like-Kind” Property Mean?

For a transaction to be eligible for 1031 treatment the assets in question must

qualify as “like-kind.” The somewhat elusive definition of “like-kind” can be

problematic. As a general rule, the definition of “like-kind” as applied to real

property is relatively broad whereas the definition when applied to exchanges of

personal property is narrower. For example, an apartment building could likely be

exchanged for a business complex or even land but gold could likely not be

exchanged for a stamp collection. Gold, however, could be exchanged for gold or

a painting for another painting in a 1031 Exchange.

What Property Is Specifically Excluded from a Section 1031 Exchange?

The Internal Revenue Code specifically excludes certain types of property from

participation in a Section 1031 Exchange, including:

Primary residence

Partnership interests

Stocks, bonds or securities

Debt

Inventory

What Is a Qualified Intermediary?

For a transaction to qualify as a Section 1031 Exchange a Qualified Intermediary,

or QI, must be used to facilitate the exchange. A QI cannot have now, or have

had in the past, a business relationship with the parties involved in the exchange

nor can the QI be a “related party” to the parties involved in the transaction.

Section 1031 Exchanges: What You Need To Know curleyrothman.com 6

Usually, a professional QI is used to facilitate the exchange. The QI holds all

funds used in the transaction and disburses them when the exchange is

complete. The QI may also hold title to property and draft documents needed for

the transaction.

How Does the Exchange Actually Work?

A typical Section 1031 Exchange operates as follows:

1. Taxpayer identifies a property to use in the exchange, referred to as the

“relinquished” property.

2. Taxpayer sells the property to a buyer who agrees to cooperate with the

Section 1031 Exchange.

3. Taxpayer enters into an agreement with a Qualified Intermediary to

facilitate the exchange. The QI is assigned the rights to the Sales

Agreement.

4. Taxpayer identifies a property to purchase, referred to as the “replacement”

property within 45 days.

5. Taxpayer agrees to purchase the replacement property from a seller who

agrees to cooperate with the Exchange.

6. The QI is assigned the rights to that Purchase Agreement.

7. The QI forwards the exchange agreements to the title or escrow company

for signature along with exchange funds.

8. Funds and titles are disbursed at the closing.

Section 1031 Exchanges: What You Need To Know curleyrothman.com 7

The 180 Day Requirement

For the transaction to receive the benefit of Section 1031 treatment very precise

timelines must be adhered to during the process. The entire exchange must be

completed within 180 days of the date of the closing on the relinquished property.

In addition, a potential replacement property needs to be identified to the QI

and/or to the closing entity within 45 days of the original sale.

Reverse Exchanges

Sometimes, a taxpayer may need or want to close on an identified replacement

property before actually selling the relinquished property. When this is the case it

is referred to as a “reverse exchange.” Reasons for entering into a reverse

exchange include, but are not limited to, the following:

A buyer for the relinquished property has yet to be identified.

Taxpayer may risk losing an exceptionally low interest rate if he/she has to

wait to purchase the replacement property.

Improvement may need to be done on the replacement property before is it

ready for the exchange.

Although the process is essentially the same in a reverse exchange, one thing is

significantly different. In a reverse exchange an Exchange Accommodator

Titleholder (EAT) must be created to hold or “park” the title to the one of the

properties because the QI cannot hold both titles at the same time. An EAT is a

usually a single member limited liability company created solely for the purpose

Section 1031 Exchanges: What You Need To Know curleyrothman.com 8

of holding title to the property and is, therefore, never used again after the

exchange is completed.

Although the basic concept behind a Section 1031 Exchange is rather simple, an

exchange can get complicated for a variety of reasons. If you are considering

entering into a Section 1031 Exchange it is in your best interest to consult with an

experienced Pennsylvania real estate attorney before beginning the process to

ensure that your transaction will qualify for 1031 according to the IRS.

Forbes, Ten Things to Know about 1031 Exchanges

Cornell University Law School, 26 U.S. Code § 1031 - Exchange of property held

for productive use or investment

Atlas, 1031 Exchange Rules and Requirements

Internal Revenue Service, Like-Kind Exchanges under IRC Section 1031

Section 1031 Exchanges: What You Need To Know curleyrothman.com 9

About Curley & Rothman, LLC

Curley & Rothman, LLC is a boutique firm of

commercial lawyers serving clients ranging from

individuals to Fortune 500 corporations in

Pennsylvania and New Jersey. We provide

clients with experienced, skilled, and honest

advice and representation in commercial and

business-related legal matters. Our mantra is

"Relentless Representation" and we hold to it.

We are determined to do everything possible to

provide you with the competitive edge you need to win.

At the Conshohocken law firm of Curley & Rothman, LLC, we understand your time and

resources are valuable, so we will not waste them by agreeing to represent you in a case in

which you cannot prevail. If we agree to take your case, it is because we are confident we can

come up with winning strategies for you. Contact us now by calling 610-834-8819 to schedule

your free consultation today.

Spring Mill Corporate Center

1100 East Hector Street

Suite 425, Conshohocken, PA 19428

www.curleyrothman.com

Phone: 610-834-8819

Fax: 610-834-8813