About 1031 Exchanges


The opportunity to protect hard-earned equity in the sale of an investment has been available to consumers since 1921. However, the complexities and details of the tax code prevented only the most knowledgeable from using this option. In 1990 the Omnibus Budget Act clarified the process and opened this option to a broader set of consumers.
Section 1031 Exchanges, which have become more popular since the mid-90s, allow investors to defer the tax on capital gains until some point in the future. Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind" while deferring the payment of federal income taxes and some state taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g., vacant land exchanged for an apartment building). Therefore, forcing the taxpayer to pay tax on a "paper" gain would be unfair.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

About Accommodators and Qualified Intermediaries

A Qualified Intermediary (QI) is a professional provider of the mandatory mechanics of an exchange. Using a QI as an independent party to facilitate a tax-deferred exchange is a safe harbor established by the Treasury Regulations. Sometimes QIs are referred to as "accommodators" or "exchange facilitators."

When the taxpayer engages in the services of a QI pursuant to an exchange agreement, the IRS does not consider the taxpayer to receive the funds. The sale proceeds go directly to the QI, which holds them until they are needed to acquire the replacement property. The QI then delivers the funds directly to the closing agent, who deeds the property directly to the taxpayer.

Without a QI and pursuant to an exchange agreement, the IRS may not define a transaction as an exchange, making it ineligible for tax deferment status.