The 1031 exchange is one of the most powerful tools for investors. The chief reason being that sellers of real estate may defer ALL their capital gains taxes. If it weren’t for the 1031 exchange, sellers would be subject to an average 30% - even up to 45% - tax on their profit.
Forward Exchange:
The most common type of exchange is the “Forward” or “Delayed” exchange, which occurs when a property is first sold (the Relinquished Property) and another property is purchased (the Replacement Property) within the 180 days following the sale of the Relinquished Property. Proceeds from the Relinquished Property must be held and safeguarded by a Qualified Intermediary between the sale and subsequent purchase of replacement property.
Partial Exchange:
Nearly a third of all exchanges performed in the U.S. each year are Partial Exchanges. A Partial Exchange is a result of a few different scenarios that may occur ultimately creating “Boot” or “New Taxable Gain.” Lets say the exchanger receives cash from the sale of the relinquished property, or left over exchange funds are received at the end of the 180 day period. Lets also say the exchanger uses exchange funds to pay Non-Exchange Expenses, all of these scenarios will result in “Taxable Boot”, meaning the exchange is partially taxable. In addition, the exchanger may purchase replacement property that is lower in value than their sale property. The price difference between the sale and the purchase would become the new taxable gain. All of the scenarios mentioned above are acceptable and will not disqualify an exchange. The exchanger still benefits greatly by deferring a majority of the gain and paying only a portion of the taxes.
Reverse Exchange:
In a Reverse Exchange, the replacement property is purchased before the sale of the relinquished property. The replacement property is acquired and held by an Exchange Accommodation Titleholder (EAT) in a special purpose entity, typically an LLC or Corporation until the sale of the relinquished property is completed within the 180 day timeframe. The EAT takes title to the Replacement Property by way of a “Qualified Exchange Accommodation Arrangement” (QEAA). At the conclusion of the reverse exchange once the Relinquished Property is sold, title to the Replacement Property is transferred from the EAT directly to the exchanger. Due to its complexity and inherent risks, a reverse exchange generally incurs much higher fees, but may be more advantageous for the taxpayer with regard to locating a replacement property.
Simultaneous Exchange:
A Simultaneous Exchange occurs when the relinquished and replacement property escrows are closed at the same time. This can happen when two properties are swapped, property for property between the same two individuals or entities, or it can also happen when the relinquished property is sold and the replacement property is purchased both on the same day. Utilizing a Qualified Intermediary will protect the tax-deferral treatment through proper structuring and documentation in accordance with Treasury Regulation 1.1031(k)-1.