Q. What is a tax-deferred exchange? A. A tax-deferred exchange is a transaction involving trade, business, or investment property, which, because it meets the requirements of Section 1031 of the Internal Revenue Code, qualifies for non-recognition of gain or loss. It's a technique for deferring gain on the sale of property by re-investing the proceeds of the sale in "like-kind" property. The theory is that if one does not cash out of an investment (having rolled over proceeds into new like-kind property), the economic gain has not been realized in a way that produces the cash to pay the tax, and so no tax should accrue.

Q. Do I permanently escape tax? No; not unless you die. The like-kind exchange rule is a tax-deferral technique. The new property purchased with the proceeds from the sale of old property has the same low tax basis as the old property. When the new property is later sold, the original deferred gain, plus any additional gain realized since the purchase of the new property, is subject to tax. Of course, one can sell the new property as part of another like-kind exchange and continue to roll over.

Q. And what if I die? A. That is when the deferral turns into permanent tax savings. Upon death, the basis of property gets "stepped-up" to fair market value and the capital gain is never taxed. Those who inherit the property can sell it at fair market value at date of death and not suffer tax on that gain. Thus the tax strategy "swap'till you drop."

Q. What type of property qualifies for a 1031 exchange? A. If the relinquished property was "held for investment" or "for use in a trade or business," and the replacement property will he held for similar use, you can effect a tax-deferred exchange. Virtually any real estate is like-kind to any other real estate (such as vacant land for a strip shopping center, an office building for an apartment building, etc.). Personal-use property (e.g., a principal or secondary residence) and property held for speculation, resale, or development does not qualify under Section 1031.

Q. What about developers? A. To have an exchange, both the old and new property must be held for investment or for use in a business. Thus, inventory is not exchangeable. A real estate developer generally cannot exchange something he builds for suit with the intent to sell when it is done. It's a similar case with a condominium development (although there are ways to structure). If you buy to flip--sorry. This is an intent test; there is no minimum holding period, however.

Q. What is a qualified intermediary? A. A qualified intermediary is an independent agent that facilitates an exchange. The taxpayer's attorney or accountant cannot be a qualified intermediary. Most intermediaries are affiliated with banks, trust companies, or title companies. Using a qualified intermediary is one way of "safe harboring" an exchange. Essentially, the qualified intermediary takes an assignment of rights in the sale contract for the old property and the purchase contract for the new property. These are simple documents that the attorney fills out, along with a basic exchange agreement with the intermediary. Through these three documents, the intermediary is brought into the exchange and, subject to compliance with the timing rules discussed below, the transaction can qualify as an exchange rather than a taxable sale.

Q. What about the money? A. The most important role of the qualified intermediary is that it holds the proceeds of sale pending reinvestment in new property. The Internal Revenue Service takes the position that if the seller receives (or has direct or indirect use of or control over) the proceeds of sale, then there should be tax. By arranging for the qualified intermediary to hold the money, the taxpayer never receives the cash and therefore the transaction can be viewed as an exchange.

Q. How much time do I have to locate and obtain my replacement property? A. When structuring a tax-deferred exchange, two time limitations are of critical importance. These include the period of time during which you must identify and the period of time during which you must acquire your replacement property. Within 45 days of the closing on the sale, the taxpayer must "identify" the new property. One must close on one or more of the identified properties within 180 days of the date of closing on the old property. This is not 45 days plus 180 days. The 45 and 180 day periods run concurrently. The 180 day period is cut short if the tax return filing deadline comes up before the end of that period; one can get the full 180 days, however, by extending the time for filing the tax return.

Q. What if I miss a deadline? A. Tough luck. There can be no extension of either of these time periods under any circumstance. If the 45th or 180th day falls on a Saturday, Sunday, or legal holiday, the identification and the exchange period are not extended to the next business day.

Q. How do I identify the replacement property? A. The Internal Revenue Service regulations set strict guidelines to satisfy the identification requirement. The identification must be specific (such as the address of property or legal description). Identification is made by sending the qualified intermediary written notice of the targeted new property.

Q. How many properties can I identify? A. The IRS regulations place restrictions on the number of properties that may be identified during the identification period. For the possibility that the deal the taxpayer wants to do may fall through, the taxpayer may designate more than one property (generally up to three, or more than three if the total value of the new properties designated is less than twice the value of the property sold). One can also identify fractional interests in property that will be held in a co-tenancy. However, if, at the end of the identification period, you have identified more properties than permitted, you are treated as if no replacement property had been identified. Accordingly, the tax-deferral exchange treatment will be denied.

Q. What is a reverse exchange? A. As of September 15, 2000, reverse exchanges (when the new property is purchased before the old property is sold) are permitted. However, you must use a special "parking intermediary" to purchase and hold the new property until the old property is sold. The old property sale can be structured as a normal "forward" exchange where the proceeds are rolled over into the new property being "warehoused" or "parked" with the parking intermediary. The parking intermediary can hold the new property for up to 180 days.

Q. What about newly constructed property? A. One can trade into newly constructed property, but one cannot own the land on which the improvements are being built. The land must be owned by either the seller, the developer, or a parking intermediary. If the taxpayer already owns the land, it can be sold to a parking intermediary or the developer. The seller or intermediary will contract to construct the improvements, and at the end of the 180 day period can convey the property (completed or partially completed) to the taxpayer to close out the exchange. This is usually a race against the clock to try to spend as many construction dollars as is necessary to complete the trade. One can not prepay construction costs.

Q. When you say proceeds need to be rolled over to avoid gain, is that all there is to it? A. No. The essence of a trade is that one has not cashed out any part of the investment. One must trade up or even on price. And one must use all of the cash proceeds from the sale. Taking this altogether, the transaction is taxable to the extent that the purchase price of the new property is less than the selling price of the old property. And the transaction is taxable to the extent that there is cash left over with the qualified intermediary after the purchase of the new property (except that if the left-over cash is attributable to real estate tax pro-rations, security deposits, or other pro-rations on the purchase of the new property, that money can often be taken off the table without creating tax). If one trades up or even in price and uses up all the cash, then the debt (comparing the mortgage on the old property to the mortgage on the new property) should be roughly the same or greater. If the debt goes down, there is potential tax unless more cash is put into the deal. One cannot borrow more on the new property as a way of trading up and taking cash out of the deal.

Q. How do I get my equity out? A. As mentioned above, one must trade up or even on price and use up all the cash. So while one can put more debt on the new property (if it costs more than the old property), one cannot refinance in the middle of the trade and take cash off the table. Typically what is done is to leverage up the old property in advance of the sale, or complete the trade and then refinance the new property to take the cash out. In both cases, the additional financing must be independent from the exchange. Refinancing after the trade is generally preferable from a tax perspective. And there are ways to structure the refinancing without incurring additional fees.

Q. How much gain do I have if I trade down? A. The way to calculate this is first to figure out what the gain would have been on an outright sale. On an exchange, one can never have more gain than that. Then look to the amount of cash that was not rolled over, or the amount by which the purchase price of the new property is less than the selling of the old property. This will be the so-called "boot." The gain is the lesser of the gain that one would have had on an outright sale or the amount of boot. For example, say that on an outright sale one would have had $50,000 of gain. On the exchange, there was $10,000 of cash that was not reinvested. The first $10,000 of gain is subject to tax. It is not one-fifth of the gain. The boot is taxed dollar for dollar off the top, subject to the limitation that there cannot be more exchange gain than on an outright sale.

Q. What is a year-end push? A. If the taxpayer sells property and deposits the exchange proceeds with a qualified intermediary in the last 179 days of the year and has a bona fide intent of doing a like-kind exchange, but the exchange does not close in the succeeding year (the 180th day must fall in the succeeding year), the gain is deferred into the succeeding year. As noted, one must have a bona fide intent to do the exchange; there are steps that a taxpayer can take with his attorney to prove up that intent in advance.

Q. What about partnership exchanges? A. One cannot exchange partnership interests, even if the partnerships own real estate. (Of course the partnership can do an exchange itself.) The same prohibition applies to interests in limited liability companies and corporations. But in the case of limited liability companies and partnerships, there are ways to structure ownership with multiple parties as co-tenancies, preserving the notion of individual ownership and avoiding partnership classification. There are special tax elections that certain partnerships and limited liability companies can make in order not to be treated as a such for income tax purposes (even if they are valid entities for state law purposes). There are ways of cashing out non-trading partners from a partnership to allow the trading partners to remain in the partnership and accomplish their sale. All of these transactions require careful structuring in advance of a transaction.

Q. What about exchanges with related parties? A. One can sell old property to a related person and still do an exchange. One cannot purchase replacement property from a related person, even if the related person pays tax on the sale.