Since the 1920s, savvy taxpayers have been growing their wealth on a tax-deferred basis by using Section 1031 like-kind exchanges. Originally used by cattle farmers to defer payment of capital-gains tax on the exchange of cattle, 1031 is currently used to defer capital-gains tax on the sale of real property, including self-storage.

All sales and exchanges are taxable, unless a provision of the Internal Revenue Code claims their gain or loss is not recognized. Section 1031 is one such proviso. The rationale behind it is when a taxpayer exchanges an asset for another that is similar, there is a continuity of investment, and he should be able to defer payment of the tax. If there is a gain, it is carried over to the new asset. It is taxed later, in the event there is a sale or exchange in which no non-recognition rule applies.

Its a simple principle, but there are many regulations you must know to gain a working knowledge of Section 1031. The following will help you navigate the process as well as provide pointers on choosing an exchange professional, known as a qualified intermediary (QI).

Exchange Types

There are four basic types of exchange: simultaneous, forward, reverse and improvement. Lets take a look at each:

Exchange Basics

For each exchange, a taxpayer must follow all the necessary regulations to qualify for tax deferral. There are several basic foundations to Section 1031:

Like-Kind Property. Assets acquired in an exchange must be like-kind to those relinquished. Generally, in real estate, any fee-simple interest is like-kind to another. A leasehold interest with a term of 30 or more years (including options) is also like-kind to a fee-simple interest.

The term like-kind refers to the nature or character of a property, not its grade or quality. The propertys use is not relevant; for example, unimproved land can be exchanged for a multifamily building. Interests other than fee interests, such as leaseholds of less than 30 years, easements and transferable development rights, raise interesting likekind issues that often require analysis of state real-property law.

Qualified Property. Property involved in a 1031 Exchange must be of a qualified use. Only relinquished property held for investment or productive use in a trade or business is eligible. The replacement property must also be held for investment or productive use in a trade or business. Excluded assets include inventory; stocks, bonds, notes and securities; and partnership interests. Personal-use property, such as a vacation home, is generally not eligible.

Time Lines. A 1031 Exchange also involves strict time restrictions. First, there is an ID period, during which the taxpayer must identify a limited number of replacement properties in writing to the QI. It begins on the day the relinquished property is sold and ends on midnight of the 45th day thereafter (irrespective of whether that day is a Saturday, Sunday or legal holiday), counting the day after the sale as day one.

The taxpayer must also adhere to timelines for the exchange period itself, which begins on the day the relinquished property is sold and ends on midnight of the 180th day thereafter (irrespective of whether that day is a Saturday, Sunday or legal holiday), counting the day after the sale as day one. He must commence and complete his entire transaction during this period; however, there is an exception: If the taxpayers tax return for the year in which the property is sold is due before the last day of the exchange period, the time frame will be less than 180 days, unless he obtains a filing extension. For example, a calendar-year taxpayer with an April 15 return due date who begins an exchange after Oct. 17 will have a shortened exchange period.

Taxpayer Identity. Also important in a 1031 exchange is taxpayer identity. For the purposes of federal income tax, the person selling the relinquished property must be the same one acquiring the replacement property. This may be an issue in situations that involve partnerships, tenant-in-common arrangements and mid-exchange corporate reorganizations. The use of a single-owner entitydisregarded as separate from the owner, such as single-member LLCto acquire replacement property will not change the identity of the taxpayer.

Proceeds. The taxpayer must avoid actual or constructive receipt of sale proceeds. If he receives proceeds from the sale of the relinquished property during the exchange period, the transaction will be a taxable sale, not a tax-deferred exchange, even if he ultimately receives property from the QI. The taxpayer can receive proceeds from a party to the transaction other than the QI, such as the buyer or the title company, at the time of sale, though the proceeds will be taxable.

Generally, there are only three circumstances in which the exchange proceeds can be released to the taxpayer:

1. At the end of the 45-day identification (ID) period, if there is no other identified property for the taxpayer to acquire.

2. At the end of the exchange period.

3. After the end of the ID period but before the end of the exchange period. This is true only if the taxpayer has acquired all of the replacement property he is entitled to receive under the exchange agreement. Otherwise, the proceeds can be used by the QI at the taxpayers direction to buy identified replacement property and pay certain transactional expenses.

There are many other regulations that must be followed to qualify for safe-harbor treatment. A QI should be able to provide you with additional information regarding the overall procedure.

Choosing the Right QI

The most important step in completing a 1031 exchange may be choosing the right QI. What should a taxpayer look for in a professional?

A Section 1031 exchange is a valuable tool that should be given consideration whenever you sell a property. The challenges that arisewhether related to partnership, timing, value or replacement propertycan often be solved. The 1031 is a strategy worth exploring because, to quote Winston Churchill, There is no such thing as a good tax.

Thomas E. St. Jean is president of Compass Exchange Advisors LLC, a Qualified Intermediary based in Kingston, Mass. He can be reached at 781.582.8000 or [email protected]. Nicholas Malagisi is president of Storage Realty Advisors, a commercial real estate brokerage firm specializing in the sale of self-storage facilities, primarily in the Northeast. Malagisi has participated in the sale of more than $93 million worth of self-storage properties since 1993. He also prepares feasibility studies for new projects. For more information, call 716.633.9601; e-mail [email protected]; visit www.storagerealty.com.