Many people have been entering the real estate market as investors for the first time and have been exploring the benefits of tax deferral using a 1031 Exchange.  Speaking with a trusted tax advisor is key to learning the requirements, but many investors have questions about how an exchange will affect their sale and how the process actually works.  Every 1031 Exchange company operates differently, but here is a sample outline of a standard delayed exchange.

Prior to Sale:

• Investor decides to sell, contracts a real estate agent, receives and accepts an offer.
• Add intent to do an exchange to the sales contract.
• Contact the qualified intermediary and authorize them to initiate the exchange.
• The intermediary will request documents from the title/closing company.  These will be used to prepare the exchange agreement.
• At closing the exchangor will sign the 1031 Exchange documents along with the other closing paperwork.
• The sales transactions closes, funds are wired to the qualified intermediary, and the 45 and 180 deadline starts.

45/180 days:

• The closing statement prepared by the closing agent will be sent to the intermediary and will indicate the exact date of sale; this will be the basis for the 45 and 180 day calculations.
• From the closing date of the sales property, the exchangor has 45 days to identify potential replacement property, in writing, to the qualified intermediary. 
• Replacement property must be purchased no later than 180 days after the sale.

Purchase:

• When the replacement property has been selected the contract for purchase should be amended to state that the purchase will be part of a 1031 Exchange. 

• The 1031 company will request documents from the title/closing company that they need to produce exchange documents for the purchase.
• The closing agent requests funds to be wired from the exchange account. 
• Client signs closing and exchange documents and takes ownership of the replacement property.  This completes the transaction.
• When the exchangor is filing their income taxes they will complete form 8824 to file their 1031 Exchange with the IRS.

§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.

We have two sources of guidance for the application of Section 1031 to vacation homes -- a letter ruling and a tax court case. In 1981 the IRS issued a Letter Ruling (Ltr Rul 8103117) that allowed a 1031 exchange on a vacation home that was sold and replaced with another vacation home. The Old Vacation Home that was sold had not been rented for the six or seven years prior to the exchange, and had been held for both "personal enjoyment" and as a "sound real estate investment." The New Vacation Home that was purchased was also intended to be held for the same personal enjoyment and investment intent.

All of these questions appear to have been answered in a recent U.S. Tax Court case (Rivera v. Commissioner). This case is significant because the U.S. Tax Court is, if you will, "The Supreme Court" of tax law, so the weight of this decision is heavy. (Although that being said, this is a Summary Opinion and carries only persuasive support -- albeit a strong one -- and not the actual precedence of law.)

The property involved in this case is a vacation home near the Lake Tahoe ski and vacation area of Truckee, California. The property had very little rental activity during the two years of the case, as well as the five or six prior years. And most of those days were personal use days by the owners; rental activity was minimal.

The amount of investor equity placed in Tenant In Common properties rose 13% in 2006 to $3.6 billion of equity placed, and the growth is projected to continue in 2007. The first quarter of 2007 reported $900 million of equity placed with a 2007 forecast of $4.5 billion for the industry as a whole.

As knowledge of TIC’s has grown, the number of sponsors packaging the investments has increased, which will bring more diversification options to investors both in property classification and geographic location. Quarter one of 2007, for example, deals closed in 22 different states across the country. The top states in number of deals closed Q1 of 2007 were: Texas-10, Arizona-5, Georgia, California and Illinois each closed 4.