What is a 1031 Exchange?

This blog post was going to be be about the best ways to show up your neighbor's Christmas light display, but  I chose instead to focus on 1031 exchanges! These can be exciting, if planned for and executed correctly. When real estate owners sell their investment, rental, business, or vacation real estate and reinvest the net proceeds in other property, this is called a 1031 tax deferred property exchange. When a property is held for this purpose, it is called a like-kind, or 1031, property. An owner must meet the requirements of Internal Revenue Code 1031 exchange in order to sell like-kind property and defer taxes on the profit of this sale.

The 1031 exchange is often referred to as a "tax free" ex­change. This not a truly tax free exchange. For qualifying properties, the 1031 exchange allows a way to defer taxes due as a re­sult of gain on the sale of commercial or investment properties. The amount of taxes deferred depends on the value of properties exchanged. If a higher value property is ex­changed for one of lesser value, so cash (or personal property) is included to compen­sate for this difference in value, capital gains tax would be due at closing for that portion that was not real property.

Section 1031 transactions don't have to involve identical types of investment properties. You can swap an apartment building for a shopping center, or a piece of undeveloped, raw land for an office or building. You can even swap a second home that you rent out for a parking lot.

There's also no limit as to how many times you can use a Section 1031 exchange. It's entirely possible to roll over the gain from your investment swaps for many years and avoid paying capital gains tax until a property is finally sold. Keep in mind, however, that gain is deferred, but not forgiven, in a like-kind exchange and you must calculate and keep track of your basis in the new property you acquired in the exchange.

Section 1031 is not for personal use. For example, you can't use it for stocks, bonds, and other securities, or personal property (with limited exceptions such as artwork).

 

Other Considerations for 1031 Exchanges

There are considerations that must be taken into account. For example, properties of unequal value, current mortgage debt, and personal residences and vacation homes all require advance planning if utilizing a 1031 exchange. 

Other Notable 1031 Considerations:

  • A 1031 Is Only For Investment/Business Property 
  • Some Personal Property Qualifies 
  • “Like-Kind” Is Broad Term 
  • A “Delayed” Exchange Is An Option
  • You Must Identify Your Replacement Property Within 45 Days 
  • You May Designate Multiple Replacement Properties
  • You Must Close Within 6 Months 
  • Cash Left Over Is Taxed
  • You Need To Consider Differences In Mortgages And Debt  

 An exchange offers the astute investor an opportunity to reinvest the federal capital gains that would normally be handed over to the IRS and put that money to work for himself. You work too hard to simply pay the tax without carefully considering this reinvestment option. Essentially, 1031 Exchanges should be thought of as an interest free loan from the IRS; one in which the principal may be increased through subsequent exchanges and may never require repayment, if you plan properly."

 

 

To learn more about 1031 Tax Deferred Property Exchange, please see the Internal Revenue Service's website here. As always, we know just enough to be dangerous. We recommend consulting your attorney to ensure that your property exchange is eligible for 1031.