Overview. Section 1031 of the Internal Revenue Code provides an exception to the general rule that gain realized on an a sale or exchange of property must be recognized. The exception applies where property held for business or investment (i.e., not for personal use) is exchanged for "like-kind" property which is also to be held for business or investment.

Like-kind for such purpose means real estate for real estate or equipment for equipment, in each case broadly speaking. It does not include intangible assets, like stock or partnership interests. The key to qualifying for the exception is that the taxpayer not have actual or constructive receipt of the sale proceeds (i.e, don’t touch the cash.)

Many tax practitioners advise their clients to take advantage of like-kind exchanges for real estate, but forget that the same advantages are available for dispositions of equipment. Similarly, they fail to recognize that "incestuous" sales (i.e., among controlled entities) not only qualify for the desired benefits, but create opportunities to "switch basis" between parcels held in different entities controlled by the same taxpayer.

Deferred exchanges. Many taxpayers avoid taxation on sale of real estate through the use of a device known as a "deferred like-kind exchange", which is a set of sales structured to avoid reporting taxable gain via falling within a safe harbor established by IRS regulations. In essence, the way it works is that the proceeds of the original sale are placed in escrow and the escrow money is used to buy the replacement property. The replacement property must be identified within 45 days after the original sale and the closing on the identified property must occur within 180 days after the original sale. For technical and historical reasons, a "qualified intermediary" is used as a straw man in the closings. Done properly, the exchange is accomplished in such a way that it has no effect on the way the closings are conducted.

Reverse exchanges. The new twist came into play in September, 2000 when the IRS adopted regulations providing a safe harbor for so-called "reverse exchanges." Under the regulations a reverse exchange is a transaction where a qualified intermediary acquires the replacement property using the taxpayer’s money and/or credit and the taxpayer then has 45 days to identify which property he or she will sell as the original property and 180 days to close on such sale.

The new safe harbor not only eliminates many theoretical difficulties in safely structuring reverse exchanges, but also make it a lot easier for the taxpayer to engage in a build-to-suit transaction with pre-tax money.

Example. Suppose a developer plans to acquire a lot and build an apartment building on it and also plans to sell some appreciated real estate. The developer’s intermediary forms Newco to acquire the lot and build the apartment building with money and credit provided by the developer. Within 45 days after Newco takes title, the developer "identifies" the property he or she wishes to sell and within 180 days after Newco takes title he or she sells the identified property, using the proceeds to acquire the lot and apartment building from the intermediary. The net effect is that the developer did not have to pay taxes on the sale of the appreciated property. Instead, he or she gets the lot and apartment building with a tax basis which is equal to the cost of the lot and building reduced by the gain not reported because of the exchange.  (Note.  A 2005 Revenue Procedure has made the above transaction more difficult if made with related parties.)