A 1031 exchange, also called a like-kind exchange, LKE, Starker Trust, or tax deferred exchange was first authorized in 1921 when Congress recognized the importance of encouraging reinvestment in business assets. Today, taxpayers use 1031 exchanges to increase cash flow by deferring taxes on gains realized through the sale of real estate, as long as they reinvest those gains in replacement property.
1031 exchange is one of the most popular tax strategies available when selling and buying real estate “held for productive use in a trade or business or for investment.” By structuring the sale and purchase of property as an exchange, the owner can potentially reduce the recognized tax gain to zero. By reducing the taxes owed to the government, more cash is available for the purchase of new property.
The Like-Kind Standard
In the case of real estate exchanges, the "like‐kind" standard is usually easy to satisfy. Generally, any type of real property interest is like‐kind to any other type of real property. The properties do not have to be of the same nature. For example, a single-family home held as rental property could be exchanged for a vacant parcel of land purchased as an investment. Learn more about the "like-kind" standard.
Eligibility for 1031 Exchanges
1031 Exchange Requirements
Once a replacement property is selected, the rights to acquire that property are assigned to the QI. The funds held in a taxpayer’s exchange account would be sent by the QI directly to the closing for the purchase of the replacement property.
Please download our step-by-step 1031 forward exchange whitepaper for detailed information about how to complete a 1031 exchange.
Any improvements are begun following a written agreement with the contractor or other service provider. This agreement is executed by the Titleholder or assigned to the Titleholder by the taxpayer if it has already been executed. The taxpayer directs funds from the exchange account to the Titleholder progressively, as the work is done. Whenever a payment is to be made by the Titleholder, the taxpayer tenders a draw approval form to the Titleholder confirming that they are satisfied with the applicable work and that the Titleholder may make payment.
The taxpayer takes ownership of the replacement property via an assignment of the membership interest in the EAT, which transfers the membership interest in the titleholder LLC and the property it holds, from the EAT to the taxpayer. Alternatively, a deed may be issued to the taxpayer by the Titleholder and the LLC may be dissolved. The taxpayer takes the membership interest or the deed for the replacement property subject to the balance of any debt.
The preceding steps outline a forward build-tosuit or property improvement exchange, in which the taxpayer sells the relinquished property prior
to the acquisition of the replacement property. If the taxpayer wishes to acquire and begin the improvements on the new property before the sale of the old property, a reverse build-to-suit or property improvement exchange is necessary.
In the case of a reverse type exchange, funding to cover the purchase price and cost of improvements must be provided to the EAT from a bank and/or taxpayer loan. In this instance, the Titleholder will sign loan documents as the borrower, and the taxpayer signs as the guarantor of the loan. Any earnest money having been put down is considered part of the funds lent from the taxpayer to the Titleholder. These loans get paid back at the conclusion of the transaction when the exchange funds are used by the taxpayer to acquire the property from the EAT.