What is Deferred Exchange?
Federal and State capital gains tax due on the sale of investment property will reduce the amount that can be offered on a replacement property. This can decrease the buying power for the investor by 20-30%. An exchange of property under Internal Revenue Code Section 1031 is a deferral of capital gains tax. Essentially it is a tax free transaction.

IRS Code, Section 1031
“Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031.”

“Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties.”

—IRS.gov Like-Kind Exchanges-Real Estate Tax Tips

Properties are of like-kind if their intended use is the same. It is not required to exchange properties of similar form (i.e. hotel for hotel, land for land). In fact; exchanges can be made with several pieces of property.

Rules of an Exchange
To avoid tax liability, an exchanger of property must adhere by these rules:

The purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property. All equity received from the sale of the relinquished property must be used to acquire the replacement property.

Tax will be recognized if either of these conditions are not met. However, partial exchanges can qualify for partial tax deferrals.

Time-Sensitive
It is important to keep in mind that a Deferred Exchange is a time-sensitive transaction. Replacement properties must be reported within 45 days of the closing date of the relinquished property and must be purchased within 180 days.

Working with a Qualified Intermediary
A Qualified Intermediary is an exchange manager that can offer legal, tax, and real estate, and financial support. They can gather information and documents concerning your exchange, they will follow your instruction on the buying and selling of property, they will advise you on actions and cost, they will notify you about exchange deadlines, and confirm transaction accuracy. A Q.I. will hold either the title of a relinquished property, a replacement property, or the proceeds of a sale. And once the transactions have been completed, they will transfer titles or monies to their appropriate destinations.

Types of Deferred Exchanges

Delayed Exchange
A delayed exchange begins with the SELLING of property by the exchangor.

The proceeds of the sale are transferred to a QUALIFIED INTERMEDIARY. The Q.I. will hold the funds for the duration of the exchange.

The second step is to IDENTIFY and report a REPLACEMENT PROPERTY or properties within 45 DAYS of the close date of the relinquished property that is EQUAL TO OR GREATER THAN the value of the NET SALES PRICE of the relinquished property. This is to assure a completely tax-free exchange.

For a successful exchange, the exchangor must acquire the replacement property within 180 DAYS of the close date of the relinquished property.

Finally, the exchangor will inform the Q.I. when the replacement property is about to close. The funds will then be released to the seller of the replacement property.

Alternative: Reverse Exchange
The type of Reverse Exchange a buyer uses is based on their means to buy a replacement property. For private financing or a cash deal, either type of Reverse Exchange can be used. For conventional financing, underwriters seldom agree to have a Qualified Intermediary (third party) hold a title, so an Exchange Last is usually required.

Exchange First
The exchangor will first TRANSFER THE TITLE of their relinquished property to a Qualified Intermediary.

The next step is for the exchangor to BUY a replacement property.

When the exchangor makes a deal to sell their relinquished property, the Q.I. will transfer the title to the buyer.

Exchange Last
First, the exchangor will BUY a replacement property and the title is immediately transferred to a Qualified Intermediary.

Then the exchangor will SELL their relinquished property to a buyer.

Once the sale is complete, the Q.I. will transfer the title of the replacement property to the exchangor.

In a Reverse Exchange the “equal to or greater than” rule applies as well as the 180 day closing deadline.