News of two exchange companies mishandling client 1031 funds has been in the news recently and has caused concern among users of the popular tax deferral strategy. The negative actions of a few are overshadowing the success and responsible approach of the many. It is important to note that 1031 Exchanges have been around for over 85 years and were intentionally established by the IRS with clear guidelines allowing taxpayers to defer gain on their investments.

Although not representative of the industry as a whole, these cases do highlight the importance of researching the company you choose to process your 1031 Exchange. As with any important decision, know whom you are choosing to do business with. Some questions to ask when researching a potential 1031 company:

Will my money be held with a large bank with online viewing of my funds
Is the money in a segregated account or mingled with other funds
Do disbursements of exchange proceeds require more than one signature
Are you bonded and insured to cover both intentional and unintentional wrongdoing
What is your experience with 1031 Exchanges and the tax code
How long has your company been in business

While not a comprehensive list, questions like these will help you know the company you will be working with and trusting to process your exchange in accordance to IRS guidelines and ethical business standards.

1031 Exchanges are also called tax-deferred exchanges which means the tax basis from the sales property is not eliminated but carried over to the property that is purchased. While the tax deferral benefits of exchanging are only allowed on investment property, Section §121 of the code has a permanent tax deduction that can be taken on the sale of a primary residence. As long as the taxpayer has lived in the property for a total of two years out of the previous five, they can claim a $250,000 deduction ($500,000 for joint filers) from their income tax. With planning, these two tax strategies can be combined to exclude the capital gains from the sale of investment property.

If an exchanger acquires a property, rents it for a number of years, moves into the property as a primary residence for at least 2 years, it is possible to then sell that residence and exclude up to $250,000 of gain ($500,000 if filing jointly) from their taxes.

In late 2004, Section §121 was revised to add a five-year holding period before a taxpayer can exclude gain under Section §121 when selling a primary residence that was acquired initially as investment property in a §1031 Exchange. For example: if the property acquired in the §1031 Exchange is rented for three years, then used as a primary residence for two years, the taxpayer will be able to sell it and exclude up to $250,000 of the gain pursuant to Section §121. The residence was owned for a minimum of 5 years and used as a primary residence for 2 out of the last 5, meeting all the requirements of the updated tax law. Thus, with careful planning, the tax deferral of §1031 Exchanges can be converted to permanent tax exclusion by combining these two tax strategies.