A 1031 Exchange is essentially a tax-deferred exchange whereby one property is “exchanged” for a like-kind property within a defined period of time. This exchange allows the property owner to defer what could be a capital gains tax liability on the property being exchanged (i.e., sold), and moreover, enables the property owner to re-invest “100 cents” on the dollar back into a similar property.
All 1031 Exchange transactions must be qualified in the eyes of the IRS and in accordance with applicable US tax code: i) properties must be “like-kind” and held for productive use in a trade or business or for investment and ii) the proceeds from a 1031 exchange sale must flow through the safe haven of a “qualified intermediary” and not through another agent or party to the transaction. Otherwise, cash proceeds are deemed to be held in “constructive receipt” by the investor, and are therefore considered taxable by the IRS.
Lastly, the total purchase price of the like-kind property should match, or be close to, the net sales price of the property being exchanged in order to avoid incurring any tax liability on the transaction. That is, equity gained from the sale of the relinquished property must be entirely re-invested in the like-kind replacement property; additionally, the replacement property should have debt encumbrance that is equal to or greater than the debt on the original property. If not, any shortfall difference (known as “boot”) is taxable in the eyes of the IRS.