What to know about 1031 Exchanges

By Gilbert F. Dukes, III, Esq.

Many tax deferred exchanges under section 1031 of the Internal Revenue Code result in
an unexpected tax liability because of incorrect legal and/or tax advice (or in some cases no
advice at all). With this in mind, this article focuses primarily on common misconceptions of
taxpayers and their advisers concerning 1031 exchanges and the tax consequences thereof, the
mistakes commonly made, and the many IRS traps in which taxpayers may fall absent a properly
structured exchange.

Definition of “Exchange” and Concept of “Intermediary:”

There is no better place to start than with the definition of an “exchange,” a simple yet
often misunderstood concept which clarifies the necessity of using a qualified intermediary. An
“exchange” occurs when a taxpayer conveys property (the “relinquished property”) to the same
party from whom such taxpayer acquires “replacement property.” Contrary to what many
taxpayers believe, if a taxpayer conveys relinquished property to a purchaser and acquires
replacement property from someone other than the purchaser, an exchange has not occurred even
if the sale and purchase close simultaneously. Absent an exchange section 1031 is inapplicable
and the taxpayer must recognize gain for income tax purposes.

Prior to the 1990s the requirement of an “exchange” created problems in that a taxpayer
desiring tax deferral under section 1031 was forced to require that the purchaser become a party
to the taxpayer’s acquisition of replacement property (as only then would the taxpayer be deemed
to have conveyed property to the same party from whom the taxpayer acquired replacement
property). The purchaser would get nervous and hire a lawyer (whose fees would often be borne
by the taxpayer conducting the exchange), complex documents would be drafted, etc.