Why 1031 Exchange?

Why does a person typically want to perform an exchange under this ruling? Exchanging or "trading up" under Section 1031 and the 2002 IRS guidelines allows owners to re-invest in larger commercial properties while also deferring capital gains taxes.

The most common reasons for exercising a 1031 Exchange are:

• Exchanging from commercial property that can't be readily refinanced, such as land, to improved property that will support a new loan. There are at least two advantages here: First, such a trade makes it possible to obtain cash. And second, trading from non-productive land for improved property can create improved cash flow for the investor.

• Exchanging from a high-appreciation property (such as a rental house or apartment) to a high-cash-flow property (such as a retail center), or vice-versa. Trading in either direction may be desirable for you, depending on what your investment objectives are.

• Exchanging from a property with high debt service payments into a property with lower payments and/or lower interest.

• Exchanging for a property that will be easier to sell in time to come. The savvy investor looks ahead, not only at what an investment will bring in terms of cash flow now and in the near-term future, but also what the long-term outlook is for that property both in terms of cash flow and in terms of eventual salability.

• Exchanging to change your lifestyle. For example, a property owner wanting to travel or retire might wish to exchange into a property requiring no management. Or a property owner who plans to move and wants to keep his/her investments in areas close to home may wish to trade a property near his/her current home for a property near his/her future home.

• Exchanging from several smaller properties to a single larger building to consolidate ownership benefits.

• Exchanging from a larger building to several smaller properties to improve liquidity or to diversify ownership, so as to spread out potential risk and minimize any possible financial hit in case of a sagging economy or other adverse factors.

• Exchanging to convert the nature of the investment. For example, exchanging from a rental house or apartment to a small medical building for the doctor who wishes to practice in a building he owns. Or exchanging from an apartment building to a retail center for an investor who believes passionately that retail centers are the investment boon of the future.

• Leases of 30 years or more may be traded for real estate. Sale lease-backs have been ruled to be exchanges, if handled properly.

The IRS and 1031 Exchanges

It all started with an investor named T.J. Starker. The delayed exchange procedure was brought to the attention of the real estate community when property-owner Starker and his family attempted to trade timberland to the Crown Zellerbach Corporation in exchange for a promise to deliver suitable trade properties to the Starkers in the future.

The IRS challenged this transaction, but Mr. Starker won out. After a series of tax court trials, the 9th Circuit Court of Appeals ruled in his favor. Subsequently, in 1991, regulations were issued that validated the use of the 1031 Exchange on a national basis.

The 1031 Exchange:

·        is an entirely legal and defensible way to defer capital gains taxes.

·        has been used thousands of times over the years.