THE 1031-TAX FREE EXCHANGE

In a 1031 Tax Free Exchange you exchange one property for another without incurring a tax on the gain. For example, assume you own an apartment building having a market value of $10 million, which you have to manage actively. You want relief from this responsibility, but your tax basis in the property is zero. If you sell for market value, you will have a $10 million taxable gain (the $10 million sale price minus your zero basis). At the 20% capital gains rate, your tax will be $2,000,000, leaving you with only $8,000,000 (the $10 million sale price minus the $2,000,000 tax). But if you exchange the project using the 1031 rules for another property, such as a $10 million shopping center, you can avoid paying the tax.

The proposition governing this treatment of an exchange of properties is quite simple. You are not terminating your investment in real estate. Rather, you are maintaining or continuing your investment through another property. Consequently, you should not have to pay a tax until such time as you make a final disposition of that investment. Putting it in the vernacular, you should not be taxed until you "cash out" of your real estate investment.

The application of this proposition is, however, governed by a series of rules that have to be carefully followed if you are to avoid being taxed on the sale.

BASIC REQUIREMENTS

To realize a tax-free exchange, you must hold the property for productive use in a trade or business or for investment for a prescribed period of time; the safe harbor is two years. You must exchange your property for property of a like kind, which you will also hold for productive use in a trade or business or for investment. These two sentences contain three basic requirements for the exchange.

You must hold both the property exchanged and the property received for productive use in either a trade or business of for investment. In the example of the exchange of the apartment project for the shopping center, you are holding both properties for investment. You comply with this requirement if one of the properties is held for investment and the other for productive use in a trade or business. You do not comply with this requirement if either of the properties is being held for personal use, such as exchanging the apartment project for an estate in which you and your family will reside.

Both the property exchanged and the one received must be of like kind. This requirement is interpreted very liberally. You can exchange the apartment project for farmland or undeveloped raw land and still be in compliance.

An exchange must occur. You cannot sell your apartment project for cash and then reinvestment the sale proceeds in the shopping center, despite the fact that they may be simultaneous transaction. There can be no intervening sale, even if you buy the center instantaneously after selling the apartment project. There has to be an exchange of the project for the center.

While no tax is due on an exchange that meets all three requirements, your adjusted basis in the property received in the exchange will be equal to your adjusted basis in the exchanged property. Since your basis in the apartment project at the time of the exchange was zero, your basis in the shopping center will also be zero, notwithstanding that both properties have a $10 million market value. You "carry over" or transfer your basis from the exchanged property to the property received in the exchange. Consequently, when you eventually sell the center, your taxable gain will be the sale price minus your basis of zero.