What is a 1031 Exchange?
A 1031 exchange (IRS Code Section 1031) gives an option to the investor by reinvesting the proceeds from the sale of investment property (known as the “relinquished property”) into qualified replacement property to defer capital gains tax. The net result is that the exchanger can use 100% of the proceeds (equity) from their sale to buy another property and defer the capital gains tax.
Property involved in a 1031 tax deferred, like kind exchange must be held for productive use in a trade or business, income production (rental) or investment purposes.
1031 "Like-Kind" Exchange Explained
1031 Like Kind Exchanges originally began as 1031 Tax Swaps of properties between two parties, often farmers trading parcels of land with one another. Over the past 20 years, the regulations regarding 1031 exchanges have become clearer and now allow investors to conduct 1031 Exchanges with more guidance. Today, 1031 tax-deferred exchanges are used by both corporations and individual property owners as part of their investment strategy.
A 1031 Exchange can potentially provide real estate owners with greater leverage, increased diversification, improved cash flow, increased potential for geographic relocation and potential property consolidation. However, there is no guarantee that these objectives can be met. As with all real estate investments, there is a degree of risk.
The strict identification and timeline rules laid down by IRS must be followed during a 1031 tax-deferred exchange. It can be a powerful wealth building tool. To ensure that every requirement of Section 1031 is met, a professional tax advisor should be utilized. Failure to do so can result in associated penalties plus immediate tax liabilities.
1031 Exchange permits investors, in addition to tax deferral, to purchase a leveraged replacement property and thus increase their basis in the amount of additional debt assumed. This can shelter as much as 50% to 60% of the rental income cash flow from income taxation. The after-tax return on investment on an annualized basis can be even greater because of the possibility of additional return from appreciation of the property.
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The following illustration below will help you understand the financial power of a 1031 exchange.
- Capital gain is taxed at a maximum capital gains tax rate of 20%
- Depreciation is recaptured at 25% (for individual taxpayers)
|Original Cost (Basis)||$200,000|
|Plus Capital Improvements||$40,000|
|Equals Adjusted Basis||$170,000|
|Less Adjusted Basis||$170,000|
|Less Costs of Sale||$80,,000|
|Equals Capital Gain||$750,000|
|Funds available for reinvestment w/o exchange (not including state capital gains due)||$766,500|
|Funds available for reinvestment w/1031 exchangers||$920,000|
If this investor decides to purchase a new property using all cash, the investor has an additional $153,500 to reinvest by utilizing a 1031 tax deferred exchange.
It’s very clearly visible why a 1031 exchange is a valuable tool for real estate investors. So have you yet spoken with your advisor, You can schedule an appointment with one of ours 1031 Experts / Advisors now for FREE.
1031 Exchange Do’s and Don’ts
DO plan in advance
The key to success in 1031 exchange is advance planning. Proper attention must be given to the timing of the sale of the relinquished property, estimating equity and debt replacement objectives to avoid boot, and retaining an expert qualified intermediary.
DO NOT miss your deadlines
The IRS will not honor the exchange if either of the two timeline are missed – the 45-day identification period , or the 180 day exchange period to acquire the replacement property.
DO make every effort to sell before you purchase
If you identify an ideal replacement property before your relinquished property is sold, then you may have to negotiate a reverse exchange (i.e., buying before selling). The IRS has provided guidance on this type of reverse exchange in Revenue Procedure 2000-37, but a reverse exchange is considered a more aggressive type of exchange as either the replacement property or the relinquished property must be parked with an Exchange Accommodator Titleholder for 180 days, pending the successful completion of the exchange.
DO NOT change the property title during the exchange
Changing how title to your property is being held or dissolving partnerships during the exchange may cause the exchange to be dishonored due to holding-period issues.