The tax deferred exchange provides property owners with one of the last true tax breaks and the only voluntary method for deferring capital gains tax on the sale of investment and business property. Unfortunately, many property owners don't capitalize on the benefits of IRC Section 1031. They continue to sell their rental property and land holdings and pay costly taxes because they are unaware of tax code provisions that allow for tax deferral. Internal Revenue Code Section 1031(a)(1) states in part "[n]o gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."

Since IRC §1031 is very liberal in its definition of "like kind," a wide range of properties will qualify for a tax deferred exchange. Examples of qualifying property are vacant land, office buildings, warehouses, farmland, single-family rental units, and shopping centers. Even leases with 30 or more years remaining are considered real property and can be traded for other real property.

How does one get started? The procedure is fairly simple. The Treasury Regulations issued in June of 1991 provide a straightforward guideline for taxpayers to follow. Once a buyer for an existing property has been found, a phone call to a selected "qualified intermediary" will begin the process. The intermediary will ask who your closing attorney and Realtor are, and will produce the necessary documentation required to facilitate the exchange. Once the closing of the existing property has occurred, the taxpayer/exchangor has forty-five days from the date of closing to identify in writing to the intermediary the possible replacement properties. Due to significant restrictions, it is usually best to identify no more than three replacement properties. The final step is to acquire one of the identified properties within 180 days from the sale date of the relinquished property.

With the reduction in capital gains tax rates a few years ago, taxpayers were given a rare break. However, this break was not as generous as originally proposed. Most taxpayers are aware of the new capital gains tax rate of 15%, lowered from the previous 20% rate. This new rate is applicable for gain generated from the sale of capital assets held for more than 12 months. At the last minute, Congress enacted a subsection that requires all gain recognized and attributed to the recapture of depreciation taken on real estate to be taxed at 25%. The significance to rental property owners is all the depreciation from May, 1997 forward is now taxed at this higher rate. Combining the 25% depreciation recapture rate with state and federal tax rates could cost a taxpayer who sells investment real estate up to 40% of their gain.

The reduction in the capital gains has helped to stimulate the economy by increasing the volume of activity in all investment arenas. Individuals who sell securities such as stocks and bonds will certainly benefit by receiving preferential tax treatment. However, owners of real estate have a significant tax advantage with IRC Section 1031 exchanges unavailable to other investors. Remember, the reduction in taxes did not equate to the elimination of taxes. The most prudent financial decision is choosing to completely defer taxes rather than giving away any profit to the government. A phone call to your nearest exchange accommodator before you sell a property is all it takes!