What Is a Tax-deferred Exchange
A tax-deferred exchange is simply a method by which a property owner trades one property for another without having to pay any federal income taxes on the transaction. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property. But in an exchange, the tax on the transaction is deferred until some time in the future, usually when the newly acquired property is sold.
These exchanges are sometimes called tax-free exchanges because the exchange transaction itself is not taxed.
Tax-deferred exchanges are authorized by Section 1031 of the Internal Revenue Code. The requirements of Section 1031 and other sections must be carefully met, but when an exchange is done properly, the tax on the transaction may be deferred.
In a exchange, a property owner simply disposes of one property and acquires another property. The transaction must be structured in such a way that it is, in fact, an exchange of one property for another, rather than the taxable sale of one property and the purchase of another.
Today, a sale and a reinvestment in a replacement property are converted into an exchange by means of an Exchange Agreement and the services of a qualified intermediary –a fourth party who helps to ensure that the exchange is structured properly.
The Parties and Properties in an Exchange
- The taxpayer (also called the exchanger): the taxpayer has property and would like to exchange it for new property.
- The seller: the seller owns the property that the taxpayer wants to acquire in the exchange.
- The buyer: the buyer is the person with cash who wants to acquire the taxpayer’s property.
- The intermediary: the intermediary plays a role in almost all exchanges today. It is usually a corporation or limited liability company. It may also be called a Qualified Intermediary or QI. It neither begins nor ends the transaction with any property. It buys and then resells the properties in return for a fee. The intermediary cannot be related to the taxpayer.
Types of Exchanges
A. The Two-Party Exchange:
Two party exchanges are rare, since in the typical Section 1031 transaction, the seller of the replacement property is not the buyer of the taxpayer’s property. As the name implies, only two parties are involved and they exchange their properties. Both steps of the transaction occur simultaneously.
B. The Simultaneous Exchange with Intermediary:
Most exchanges today employ the services of an intermediary–a straw party whose sole purpose in the transaction is to facilitate the exchange.
In a simultaneous exchange with an intermediary, title to the relinquished property is transferred directly to the buyer. The buyer pays cash to the intermediary. The intermediary pays cash to the seller who transfers title to the replacement property directly to the taxpayer. The taxpayer thus avoids receiving any cash during the transaction, which would be immediately taxable.
C. The Deferred Exchange with Intermediary:
Sometimes, at the time when the relinquished property is transferred to the buyer, the taxpayer does not yet know what property he or she wants to acquire. When that is the case, a deferred exchange is necessary.
The structure of the deferred exchange with intermediary is essentially the same as the simultaneous exchange with intermediary, except that, because the replacement property is not known at the time the relinquished property is transferred to the buyer, the two legs of the exchange take place at different times.
The taxpayer has 45 days to identify the property he or she wants as the replacement property. The transfer of the replacement property must still close within 180 days of the transfer of the relinquished property.