Equity and Gain are both important to an exchange, but they are never the same number. Let's take a cursory look at how you determine both equity and gain? First equity represents the hard-earned value that is yours in any property you own. So, if you take your gross selling price and subtract your closing expenses or closing costs, and then further subtract the amount of any debt, that remaining number which is left over will be your equity.

Now how about capital gain? Well in order to determine gain we need to know what is called your costs basis. And your cost basis is going to be informed by when you bought the property. So when you bought the property you had a purchase price correct? Well that will be the start of your cost basis, which actually changes over time. For instance, if you've done any improvements to the property that amount should be added. And likewise, if you've deducted any depreciation while you've owned the property that will be subtracted. Therefore, lets determine your cost basis and gain this way: Let's find our final cost basis or adjusted basis. That will be our original purchase price, plus any improvement, and then less any depreciation, that gives us our final adjusted basis. Now let's once again take that net selling price from our sale, deduct our final adjusted basis, and bingo, that's our capital gain.

One last thing. Here is a very simple rule that works in exchanges if you want to have a totally tax-deferred transaction. And that is …. do these two things and your exchange should be tax free. Number 1, buy a replacement property that is equal or greater in value than your net selling price, and 2) move all your equity from the old property into the new one. If you do those two things, plus replace your debt, your exchange should be completely tax deferred.

Any tax deferred exchange completed pursuant to Section 1031 needs to involve like kind properties. So what is the definition of like kind? Well, first, it is important to remember that like kind refers more to the way a property is used rather than the way it looks. For instance, the typical single family detached home can be both a personal residence or an income property, right? Okay, so then the definition for like kind essentially boils down to you needing to use your property in one of two ways. And those two methods which make up like kind are property held for investment, and property held for a productive use in a trade or business. Basically, property held for income. So, as you are out looking for candidate replacement properties, make sure your use of that new property will fit within one of those two categories. And that is the definition of like-kind.

What Is The Definition Of A 1031 Exchange? Currently, the Internal Revenue Service considers a tax deferred exchange a real estate transaction in which an investment or income property is sold and replaced within 180 days with other like-kind property. There are several different types of tax deferred exchanges however they all include the same 180 day exchange period as well as a 45 day identification period which starts when the first property is closed. Prior to the end of the Identification period which runs concurrently with the exchange period, Exchangers must identify candidate or targeted replacement properties in which they are interested and any property the Exchager acquires must be a property which they previously identified.

The IRS has set forth two rules and one exception for identification which can be found here.

Any property owner or investor who expects to acquire replacement property subsequent to the sale of his existing property should consider an exchange. To do otherwise would necessitate the payment of capital gain taxes in amounts which can exceed 20%-30%, depending on the appropriate combined federal and state tax rates. In other words, when purchasing replacement property without the benefit of an exchange, your buying power is dramatically reduced and represents only 70%-80% of what it did previously.

Tax deferred exchanging has been around since 1921. However at that time, all exchanges were Simultaneous exchanges. Meaning of course that all the properties involved in the exchange needed to close on the same day. Not an easy task!

However in the late seventies, an Oregon property owner by the name of T.J. Starker changed the entire trajectory of tax deferred exchanging when he sold some timberland to Crown Zellerbach. However, instead of receiving cash in the sale, the Starker took a credit on the books of the company. Then, over the course of about five years, as the Starker family found replacement property they wanted, Crown Zellerbach would buy it and have it deeded to them and applied against their credit on the company books.

Well, you can imagine that the Internal Revenue Service was unimpressed with this entire approach so they disallowed it and everything ended up in tax court. But interestingly enough, what actually arose from all the proceeding was that the delayed exchange concept was upheld. Granted, not every single of the Starker transfers were found to be compliant. But enough were, so that for the period between the Starker case law rulings and 1984, delayed exchanges could actually be completed legitimately in the circuit which heard the original case.

Well obviously, if you no longer had to close everything simultaneously, you'd do a delayed or deferred exchange yourself. So naturally, exchange volume increased. In fact, it increased to such an extent, that the Internal Revenue Service went ahead and codified delayed exchanging in 1984 simply in an effort to get some control around the whole process. For instance, that's where our 180 day time frame and identification rules came from.

Since then we've gotten rules for reverse exchanges which make them easier to easier to complete as well as several Revenue Procedures and other forms of Guidance that deal with many other forms of exchanging.

The reverse exchange is actually a misnomer. It represents an exchange in which the Exchanger locates a replacement property and wants to acquire it before the actual closing of the relinquished or exchange property. Since the Exchanger cannot purchase the replacement and later exchange into property that he already owns, he must find a method to acquire the replacement property and still maintain the integrity of his exchange. Reverses are typically accomplished in two formats based upon transaction logistics and the financing needs of the Exchanger. The least common is utilized only when the Exchanger requires traditional financing to complete his acquisition of the replacement property. Since few lenders would lend dollars to the Exchanger with the facilitator or Qualified Intermediary creating an LLC (known in this case as an Exchange Accommodation Titleholder) on title, it is necessary for the facilitator to warehouse or hold the title to the relinquished property. In this approach, the exchange is complete at the moment the Exchanger accepts the title to the new replacement property. However, with the prospect of the exchange being complete, it is necessary to balance equities between relinquished and replacement, prior to closing. In other words, upon closing the replacement, there must be an equal amount of equity in the replacement property as is expected to come out of the later sale of the relinquished property. Then, at the time of the later sale of the relinquished or exchange property, any debt is retired and the Exchanger is repaid any dollars which he advanced for the replacement property acquisition. In the most common scenario, the facilitator, with the aid of a loan from the Exchanger, acquires the replacement property and warehouses or holds the property title until such time as the relinquished property is sold and the exchange can be completed. Once the relinquished property is sold the replacement property can be deeded to the Exchanger or the Exchange Accommodation Titleholder LLC is assigned to the Exchanger.

At this point we need to insert several caveats regarding reverse exchanges. They tend to be more complicated than other exchanges and because they involve the holding of title by a facilitator in the form of an Exchange Accommodation Titleholder, and they require extensive planning.

Do not undertake a reverse exchange without the assistance of an experienced and knowledgeable facilitator or intermediary.

Although the vast majority of exchanges occurring presently are delayed exchanges, let us briefly explain a few other exchanging alternatives.

Simultaneous Exchanges

Investors have been doing simultaneous exchange s since the 1920's. In fact, prior to Congress modifying the Internal Revenue Code as to exchanges and formally approving the concept of delayed exchanging, virtually all exchanges were of the simultaneous type. To qualify as a simultaneous exchange, both the relinquished property and the replacement property must close and record on the same day.

Improvement and Construction Exchanges

In some cases, the replacement property requires new construction or significant improvements to be completed in order to make it viable for the specific purpose that an Exchanger has intended for it. This construction or improvements can be accomplished as part of a structured exchange process, with payments to contractors and other suppliers being made by the facilitator out of funds held in a trust account. Therefore, for instance if the replacement property is of lesser value than the relinquished property at the time of the original transaction, the improvement or construction costs can bring the value of the replacement property up to an exchange level or value which would be equal to the relinquished thereby allowing the transaction to remain tax free. Improvement and construction exchanges can be tricky however. That's because the process does require the use of a concept which we use in reverse exchanges. Namely, a warehousing of the title until such a time as the improvements are done or the 180 days is close. This is because technically you cannot exchange into property you already own. So if you bought the replacement and then did the improvements, the value you added would not count towards the exchange. That is why we use what is called an EAT or exchange accommodation titleholder.

Reverse Exchanges

The reverse exchange is actually a misnomer. It represents an exchange in which the Exchanger locates a replacement property and wants to acquire it before the actual closing of the relinquished or exchange property. Since the Exchanger cannot purchase the replacement and later exchange into property that he already owns, he must find a method to acquire the replacement property and still maintain the integrity of his exchange. Reverses are typically accomplished in two formats based upon transaction logistics and the financing needs of the Exchanger. The Exchange Last strategy is utilized only when the Exchanger requires traditional financing to complete his acquisition of the replacement property. Since few lenders would lend dollars to the Exchanger with the facilitator or Qualified Intermediary (known in this case as an Exchange Accommodation Titleholder) on title, it is necessary for the facilitator to warehouse or hold the title to the relinquished property. In this approach, the exchange is complete at the moment the Exchanger accepts the title to the new replacement property. However, with the prospect of the exchange being complete, it is necessary to balance equities between relinquished and replacement, prior to closing. In other words, upon closing the replacement, there must be an equal amount of equity in the replacement property as is expected to come out of the later sale of the relinquished property. Then, at the time of the later sale of the relinquished or exchange property, any debt is retired and the Exchanger is repaid any dollars which he advanced for the replacement property acquisition. In an Exchange First scenario, the facilitator, with the aid of a loan from the Exchanger, acquires the replacement property and warehouses or holds the property title until such time as the relinquished property is sold and the exchange can be completed.

At this point we need to insert several caveats regarding reverse exchanges. They tend to be more complicated than other exchanges and because they involve the holding of title by a facilitator in the form of an Exchange Accommodation Titleholder, they require extensive planning. Do not undertake a reverse exchange without the assistance of an experienced and knowledgeable facilitator or intermediary.

Delayed or Deferred Exchanges

Generally, when one discusses exchanges, the type of exchange referred to is the delayed or Starker exchange. This term comes from the name of the Exchanger who was first challenged for a delayed exchange by the IRS. From this tax court conflict came the code change in 1984 that formally recognized the delayed exchange for the first time. As mentioned earlier, this is now the most common type of exchange. In a delayed exchange, the relinquished property is sold at Time 1, and after a delay, the replacement property is acquired at Time 2. The timing requirements are these: you have a total of 180 days or the due date of your tax return to complete an exchange. That is the exchange period. And, the first 45 days of the 180 is known as the identification period in which you need to identify some candidate or target properties to serve as your replacement. And that's the types of exchanges.