The information presented here is intended solely for informational purposes. Owners should rely on professional legal advice before entering into one of these transactions.

Sec. 1031 of the Internal Revenue Code provides a powerful way for apartment building owners to build wealth through the “exchange” of properties held for investment.

The rules are complicated and inflexible, yet the Sec. 1031 exchange is a valuable opportunity for investors to consider.

The chief advantage of an exchange is the ability to defer payment of federal income tax on the capital gain (if any) from the sale of one property when another property is purchased with the proceeds of the sale and other strict criteria are met. The tax liability on the capital gain that results from the sale of the disposed-of property is not eliminated; rather, it is deferred and would become due if the replacement property or any subsequent replacement property were sold without the benefit of a Sec. 1031 exchange.

There are two escape hatches through which all or part of the capital gain tax liability can be eliminated. First, up to $250,000 of the tax liability for an individual or $500,000 for a married couple could be eliminated if the investment property (e.g., a single-family rental house or condominium) were converted into the owner’s primary residence (with certain other criteria). Second, the entire capital gains tax liability could be wiped out if the owner died and his or her heirs received the automatic stepped-up tax basis in the property.

The experiences of Miles King, an investor and commercial property broker/associate with Colorado Group in Boulder, Colo., illustrate the benefits of a Sec. 1031 exchange. King has been involved in nearly a dozen exchanges, several for his own account and the others on behalf of clients. His first exchange, in 1996, involved the sale of a $234,000, four-unit apartment building in Longmont, Colo. The property provided some cash flow but little leverage because the loan was nearly paid off. It was also in a location King didn’t like. The replacement property was a $785,000, 75,000-square-foot office building in nearby Boulder.

“We ended up with significantly more cash flow, more depreciation for tax purposes, a better location and tenants who were interested in their surroundings being nice. It was my first experience (with Sec. 1031), and it was great,” he said.

King’s most recent exchange involved the purchase of a $695,000,

17-unit apartment building in Greeley, Colo., a college town, in December 2005. A line of credit from a local bank financed the all-cash transaction. King plans to invest $80,000 in improvements to help lease up the half-vacant building and generate $20,000-plus in annual cash flow. A permanent loan will replace the line of credit funds.

The building was purchased in the name of an exchange accommodator’s limited liability company, which will own the property until King sells a $320,000 single-family house in Boulder that is leased to tenants. The house produced only $800 of cash flow last year after investments in various physical upgrades. This is an example of a “reverse exchange” in which the replacement was purchased before the sale of the disposed-of property.

Swaps must comply with rules

Here are four basic rules of 1031 exchanges from Ralph Bunje, founder and chairman of Independent Exchange Services in San Francisco:

1. Both properties must be “like-kind,” meaning they’re owned not for personal use, but as an investment.

2. The equity and sales price of the replacement property must be higher than the equity and sales price of the disposed-of property to defer the entire taxable capital gain.

3. The replacement property must be identified within 45 days and the purchase of that property must close within 180 days after the sale of the disposed-of property.

4. Exchanges are subject to documentation, procedures and the involvement of a third-party exchange “accommodator,” which holds the cash from the sale of the disposed-of property until the replacement property has been purchased or, in the case of a reverse exchange, holds the replacement property until the disposed-of property has been sold.

Investors can extract cash or other value, known as “boot,” from the exchange and pay whatever tax is owed, but at some point, the amount of cash or reduction in value of the investment could be so substantial that the exchange would afford little or no benefit, warned Dennis Helmick, president of Exchange Facilitator Corp. in Seattle.

To avoid the tax consequences of “inadvertent boot,” buyers can pay cash at closing for such items on the settlement statement as tenant damage deposits, prorated rents, utility escrows or prorated tax payments, advised Larry Jensen, president of 1031 Corp. in Longmont, Colo.

A potential disadvantage of an exchange is the lower depreciation on the replacement property, Jensen noted. It’s possible, though not easy, to estimate the potential impact of this factor. However, many investors don’t want to make the necessary calculations, which involve the time value of money, or don’t want to take this factor into account because future interest rates and capital gain tax rates are uncertain.

“You can calculate the present value of the tax benefits with the higher tax basis, but taxpayers don’t want to think about the next 27.5 years. And who knows? Maybe the tax rates will change,” he said.

The most worrisome pitfall for investors is the 45-day rule, on which “everyone stubs their toe,” Helmick said.

In a forward exchange, the seller should “have a solid contract on whatever they want to buy at the end of the 45 days and maybe have some backups identified,” Jensen advised. “Without a contract, you just have a wish list, and sometimes contracts fail.”

A reverse exchange eliminates the 45-day rule.

Oftentimes, an investor who has sold one property, but hasn’t been able to locate a desirable replacement property will want to solve that problem by buying a house from his or her parents, siblings or children, who are perhaps in some financial trouble, and renting the house back to them as an investment property, Helmick said.

But transactions with related parties (i.e., grandparents, children or siblings) cannot qualify as Sec. 1031 exchanges.

An Internal Revenue Service private-letter ruling in 2004 suggested the ban on related parties wouldn’t apply if the related party also completed an exchange and didn’t receive any cash from the transaction, Jensen noted. Expert advice should be sought on this subject.

Tenant-in-common interests can be bought or sold within a Sec. 1031 exchange, though Jensen cautions that no established resale market exists for these investments and exit strategies may not be well established.