Balancing the Exchange – Full Tax Deferral


In general, an I.R.C. §1031 Exchange (“Exchange”) allows owners of business or investment real estate to defer the recognition of all or most of the capital gains taxes and depreciation recapture normally due upon the sale of the property so long as they use the net proceeds to buy replacement business or investment real estate, within 180 days. An Exchange is a tax strategy that with proper planning, can be utilized to defer capital gains tax liability, preserve equity, increase purchasing power, and as a result increase annual returns on the investment.

Balancing the Exchange – one of the key concepts in structuring a full tax deferred exchange is that through reinvestment of the net proceeds (net equity) from a sale and the replacement of the existing debt on the property, a taxpayer will not realize the capital gains tax liability normally due upon the sale of real estate. One way to look at it is that the tax attributes from the relinquished property carry over like baggage into the replacement property and the taxpayer is swapping the benefits of owning one property for another, but not incurring a tax liability because they continued their investment in real estate.

Please be aware that in order to have a fully tax deferred exchange, an exchanger should do all the following:

  • Purchase replacement property of equal or greater value to the relinquished property (less allowable closing costs).
  • Reinvest all the net proceeds from the relinquished sale into the replacement property purchase. (i.e. – the “cash proceeds” after paying off closing costs and any mortgages or liens – this amount should be all the net equity, including the adjusted basis).
  • Obtain equal or greater financing on the replacement property as was paid off on the relinquished property or replace all or some of the debt with new cash if not financing or if using less financing.
  • Receive nothing except like-kind property. Both the relinquished (sale) property and the replacement (purchase) property must be held for productive use is a trade or business or held for investment purposes in order to qualify. Any cash received is not like-kind to real estate.

If an exchanger violates any or all these rules, he/she may still have a valid exchange, but they may recognize some capital gains and have some tax liability (“partial exchange”). Exchangers should check with their tax advisor to determine the amount of gain that they will recognize on their yearly tax returns (federal and state) because they could have other tax attributes and offsets, which in effect would reduce their tax liability.

The exchanger needs to know their adjusted basis to calculate their profit and corresponding tax liability. Adjusted basis is the initial purchase price less depreciation plus capital improvements – on a partial exchange, a CPA should provide this information, along with the exchanger’s estimated tax liability. An exchanger only benefits to the extent that they spend more than their adjusted basis on the replacement property.

Because we act as a qualified intermediary, we are not permitted to provide our exchange clients with tax or legal advice. Accordingly, please use this information as a starting point for a conversation with your accountant or tax attorney about structuring your exchange.

Legal 1031 Exchange Services, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. Property owners must consult their tax and/or legal advisors for this information. Our role is limited to serving as qualified intermediary to facilitate your exchange.
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