Section 1031 (a)(1) of the Internal Revenue Code states that “No 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.”

The sale of real estate is a taxable event, and all profit from the sale of real estate is taxed as capital gains. If your property has appreciated in market value, you will be required to pay capital gains taxes and recapture of depreciation. Section 1031 exchanges – if done properly – have the special benefit of allowing the complete legal avoidance of capital gains taxes and recapture of depreciation.

Every one of these elements is necessary for a valid 1031 exchange. If any one of these elements fails, the IRS will not recognize the transaction as a 1031 exchange but as a sale and you will be required to pay capital gains taxes.

You must begin a 1031 exchange with ownership of a tangible property that is qualified for an exchange.

First, what is being exchanged must be tangible property. You can only exchange tangible property for tangible property (such as land, buildings, mineral deposits, or uncut timber), not a security (such as stocks and bonds), services, or a lease or rental interest.

Second, both the relinquished property and the replacement property must be “held for productive use in a trade or business, or for investment.” Personal use property such as a personal residence does not qualify, nor does property held primarily for resale.

The replacement property, like the relinquished property, must meet certain requirements to be eligible for a 1031 exchange. The major requirement is that the replacement property be “like-kind” to the relinquished property. First, the replacement property, like the relinquished property, must be property, not securities or services, and it must be intended for “productive use in a trade or business or for investment.” “Like-kind” property does not mean property that is exactly alike – or even alike at all in any normal sense. Instead, the IRS interprets the “like-kind” requirement very broadly – so broadly that if two or more properties are located in the United States and are held for productive use in a trade or business or for investment, they are considered “like-kind” property under Section 1031.

The taxpayer is allowed a strictly limited period of time between the transfer of the relinquished property and receiving the replacement property, and is barred from receiving the funds from the transfer of property until the completion of the exchange. If you receive any proceeds from the transfer of the relinquished property at any time before the completion of the transaction – that is, at any time before escrow closes on the replacement property – the exchange instantly becomes a taxable sale. The IRS strictly enforces these time limits.

In any deferred property exchange under Section 1031, there are two crucial time limitations:

Both time periods begin to run on the same day – the day that the taxpayer transfers the relinquished property – and both time periods run simultaneously. You have only a maximum of 180 days to complete the entire transaction.

It is also important to keep in mind that if the exchange involves the transfer of more than one relinquished property and the relinquished properties are transferred on different dates, both the identification period and the exchange period begin to run on the earliest date on which any of the relinquished properties are transferred.

All replacement properties to be received must be identified within 45 days after the taxpayer transfers the relinquished property. The identification period begins on the date that the taxpayer transfers the relinquished property and ends at midnight 45 days thereafter. For example, if you transfer your relinquished property on August 1, you must identify qualified replacement property on or before midnight on September 15. If you identify qualified replacement property on September 16 or later, there can be no 1031 exchange and any profit from the transaction will be taxed as capital gain.

Note, too, that that both the 45-day identification time period and the180-day exchange time period include Saturdays, Sundays, and legal holidays. If the 45th day or the 180th day falls on a Saturday or Sunday, you must complete the required action on the prior Friday. Similarly, if the 45th day or the 180th day falls on Christmas or Thanksgiving, you must complete the required action on the day before the holiday.

Under The Three-Property Rule, the exchanger identifies a maximum of three potential replacement properties. These properties can have any individual fair market value and can add up to any fair market value.

Under The Two Hundred Percent Rule, the exchanger identifies as many potential replacement properties as he or she wants, any number of which can ultimately be exchanged for the relinquished property within the 180-day time period, so long as the total fair market value of all of the identified properties is not more than 200 percent of the value of the relinquished property.

Under The Ninety-Five Percent Rule, the exchanger identifies any number of potential replacement properties without regard to their total fair market value and must ultimately receive 95 percent of the total fair market value of all the identified replacement properties within the 180-day exchange time period.

Since the taxpayer can not receive the proceeds from the relinquished property until title to the replacement property is obtained, and these same proceeds are used to acquire that replacement property, someone needs to hold on to the funds, acquire the relinquished property from the taxpayer; transfer the relinquished property to another party, acquire the replacement property from another party, and then finally transfer the replacement property to the taxpayer. This is the job of the Qualified Intermediary.

A Qualified Intermediary (also sometimes called a QI or an accommodator) is a person or business entity that holds the exchange proceeds and acts as a “safe harbor” or barrier between the taxpayer and the proceeds from the transfer of the exchange property, so that these proceeds never come into your actual or constructive possession, but at the same time can be used to obtain new property for you. The sale proceeds go directly to the Qualified Intermediary, who holds them until they are needed to acquire the replacement property. The Qualified Intermediary then delivers the funds directly to the closing agent. If the taxpayer meets the requirements of this safe harbor, the IRS will not consider the taxpayer to be in receipt of the funds.

Because the proceeds can never come into your actual or constructive possession before the completion of the exchange, there are limitations on who can serve as a Qualified Intermediary in a 1031 exchange. Anyone who is an agent of the taxpayer at the time of the transaction, or has been an agent of the taxpayer within the past two years, is disqualified from being a Qualified Intermediary of the taxpayer. This prohibition includes anyone who has been the taxpayer’s employee, attorney, accountant, investment banker or broker, real estate broker or agent within the past two years from the date of the transfer of the first of the relinquished properties. In practical terms, this prohibition eliminates your present lawyer or accountant from serving as your Qualified Intermediary. However, assuming there are no other disqualifying activities or relationships, you may use a real estate agent who has previously helped to put together a 1031 exchange for you, as well as a business entity or person who has performed routine financial, title insurance, escrow, or trust services for you.

You should also take special note of the Qualified Intermediary’s fund management program, asking in whose name the funds are held and where, and what the requirements are for deposits and withdrawals. In addition, you should also make sure that your Qualified Intermediary is experienced in the 1031 exchange process. Remember that the rules governing the use of the proceeds of the various transactions in 1031 exchanges can be complicated, and that a mistake by your Qualified Intermediary can result in you paying thousands of dollars in taxes that could, and should, be avoided. Remember, too, that it is not the job of the Qualified Intermediary to provide legal or specific tax advice to the exchanger. On these critical matters, you must have expert and trustworthy advise from other professionals.

Your broker should know the real estate market where your relinquished property is located, as well as the real estate market where you would like to acquire replacement property. Of course, your broker should also be experienced in navigating through the 1031 exchange process, and particularly with its strictly enforced time limits.

Perhaps most importantly, your real estate broker should have access to a large network of properties and be someone you can count on to provide you with both a wide range and an extensive number of possible replacements properties that meet your personal and financial goals, as well as help you cut through and narrow down these potentially overwhelming possibilities. Your broker should be able to provide expert recommendations regarding which of the replacement property identification options you want to use (The Three Property Rule, The Ninety Percent Rule, or The Two Hundred Percent Rule), and direct you to replacement properties that will close escrow within the law’s strict time limits.

Whatever you do with your property has tax consequences that must be considered. Because the full extent of these consequences can be quite complex, it makes good sense to consult with a knowledgeable tax advisor before you make the decision to exchange and before you begin the 1031 exchange process. You will need a tax advisor who knows the Tax Code and the IRS requirements, has been through the 1031 exchange process before, and knows how to avoid the pitfalls that can cost you money.

First, you want to be sure that an exchange under Section 1031 will, in fact, help you achieve your particular personal and financial goals. You will need to determine, as precisely as you can whether, and how much, you will benefit from avoiding capital gains taxes and recapture of depreciation on the transfer of your property.

Second, you want to be sure that your property is qualified for a 1031 exchange. Since the IRS looks, in part, to how you have treated your property in prior tax returns to determine whether it qualifies for a 1031exchange, you will want to have someone who is familiar with those tax returns to now review them for their impact on qualifying for an exchange. Ideally, the tax advisor who prepared those returns will be able to assess their impact on your 1031 exchange, but only if he or she is also knowledgeable about the specifics of a 1031 exchange.

While the benefits of a 1031 exchange are enticing on their own – tax deferral with reinvestment of 100% of the proceeds – these benefits can be compounded when ordinary real estate is exchanged for a Tenancy-in-Common (TIC).

In fact, TICs are rapidly becoming the preferred form of real property ownership for investors who want to benefit both from the avoidance of capital gains taxes and recapture of depreciation under Section 1031 and also want to significantly improve the quality and stability of their real estate investment. In a TIC transaction, all due diligence has already been completed and the risk of falling to close escrow in time is greatly diminished.

TICs allow investors to own a percentage of a significantly larger and more expensive property in an entirely different market with a more stabile and potentially far greater income stream. And because TICs are qualified “like-kind” real property, they can be exchanged under Section 1031 for any other qualified real property.

TICs also allow you to use a 1031 exchange to diversify your real estate investment, since you can exchange a single relinquished property for TIC ownership interests in several distinct properties. You can, for example, exchange a single multi-unit rental property for TIC interests in an office building, a shopping mall, and an apartment complex.

TICs also allow individual investors to own a percentage of larger of and/or more expensive rental property, such as multi-family apartment complexes, office buildings, and triple net leased shopping malls, and participate in a more stable and potentially greater revenue stream from rent, without the headaches and hassles of individual property management. By eliminating the headaches and hassles of direct property management (collecting rent, avoiding vacancies, negotiating leases, demands for repairs, and other tenant complaints, dealing with delinquencies, evictions, zoning issues, and the threat of nuisance lawsuits), TIC ownership offers the real estate investor the same kind of “arm chair” investing as stocks, bonds, trusts, and other securities, while also allowing for the indefinite deferral of capital gains taxes and recapture of depreciation.