Tax deferred exchanges can be arranged for the tax deferred transfer of either personal residences or investment and income property.This potential tax deferred method of transferring property is critical to the property owner who desires to sell a property, but is hesitant because of the large amount of capital gain tax which would be due upon a traditional sale.

Tax free or tax deferred exchanges can be very beneficial because the gain tax which is normally due upon sale, can be deferred into another property. The IRS will allow the exchange of properties without the payment of gains tax, provided several rules are met and the equity from the exchanged property is simply transferred into the replacement property.

The rules which govern the tax free transfer of personal residences and investment properties are different. The personal residence provisions are found in Section 1034 of the Internal Revenue Code and those regarding investment property are located in Section 1031.

For the benefit of this article, we will address those exchanges which are completed within the provisions set forth in Section 1031, investment and income property exchanges.

Two main criteria identify those types of property which qualify to be exchanged tax free or tax deferred, under Section 1031. These criteria define the types of property which qualify as “like-kind” in the opinion of the Internal Revenue Service. This like kind distinction is important because the IRS has determined that the like kind aspect of the exchange is central to the validity of the entire transaction. Therefore, the two types of property which are designated as exchangeable within the regulations set forth by the IRS are:

1. property held for investment, and/or
2. property held within in the productive use of a trade or business.

Once a property owner has determined if his property qualifies within the regulations, he must accomplish two distinct tasks in order to completely defer all gain taxes on the exchange transaction. The first is to acquire a replacement property which has a valuation which is equal or greater than the net sales price of the exchange property. The second component is to transfer all equity from the exchange property into the replacement or acquired property. If these two items are completed successfully, the transaction will occur tax free.

Within the scope of qualified tax deferred exchanges, other important rules and provisions exist. These rules primarily deal with delayed exchanges, where a delay occurs between the time one property is sold and the replacement property acquired. The rules set forth the time frame in which the entire exchange transaction must take place, a maximum of 180 days; and the approved methods which have been created by the IRS in which to identify the replacement property which is to be acquired.

The rules regarding the identification of potential replacement properties are important and central to completing an exchange which will qualify with the IRS for deferred gain treatment. The rules (three property, 200%, and the 95% exception), should be considered with the aid of an experienced tax advisor and qualified exchange intermediary.

The reasons to contemplate an exchange are as varied as the individual motivations for selling and buying property. Some property owners want to move into a larger investment. Some simply want to restructure their investment to ease management concerns or relocate their property. Whatever the reason, tax free or tax deferred exchanges can provide a great way to sell property without the burden of incurring gain taxes.