What is a §1031 Exchange?

Capital Gains Tax, 1031 ExchangeThanks to Internal Revenue Code, Section 1031, a properly structured §1031 exchange rules allow an investor to sell a property, to reinvest the proceeds in a “like kind” new property and to defer all capital gain taxes.  IRC Section 1031 (a)(1) states:

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

Peak Realty Advisors, a Phoenix based professional real estate brokerage suggests, to understand the powerful protection a §1031 exchange offers, consider the following example:

  • An investor has a $200,000 capital gain and incurs a tax liability of approximately $70,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold.  Only $130,000 remains to reinvest in another property.
  • Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property.
  • If the same investor chose to exchange, however, he or she would be able to reinvest the entire $200,000 of equity in the purchase of $800,000 in real estate, assuming the same down payment and loan-to-value ratios.

As the above example demonstrates, exchanges protect investors from capital gain taxes as well as facilitating significant portfolio growth and increased return on investment.  In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the IRC.  For instance, an accurate understanding of the key term like-kind – often mistakenly thought to mean the same exact types of property – can reveal possibilities that might have been dismissed or overlooked.

As a general rule of thumb, to avoid paying any capital gain taxes in an exchange, the investor should always attempt to:  1) Purchase equal or greater in value; 2) reinvest all of the equity in replacement property; and 3) Obtain equal or greater debt on replacement property.

Investors can use a §1031 exchange to sell multiple properties and purchase one, sell one and purchase multiple properties, or sell multiples and purchase multiples.  Obviously, any time you are buying or selling multiple properties within the constraints of a given time period, the necessity of task management intensifies.

The §1031 exchange tax strategy can be a great tool to enhance investment opportunity.  However, the importance in working with professionals can’t be overstated, mistakes can be costly to remedy including taxes, penalties and interest.  This brief overview can’t possibly touch on the many potential pitfalls including hold time requirements of real estate, selling to related parties, and etc..  The opportunities for exchange failure are easily managed however with knowledge, planning and timely execution.

Notice:  Peak Realty Advisors, a professional real estate brokerage affiliates with and recommends experts, each with specialties in associated areas including, qualified intermediary, legal, tax, funding, and escrow, all companies proven to serve as your resources to obtain accurate and thorough information about the entire exchange process.

§1031 Exchange, Basic Statutory Requirements
§1031 Exchange Terminology
§1031 Exchange, Process Checklist

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