A 1031 exchange in real estate is essentially a swap or exchange of one investment property for another so the investor (property owner) can defer capital gains taxes.
Key Takeaways about 1031 Exchanges in Real Estate
- 1031 exchange is a property swap that is held for business or investment purposes.
- The properties swapped must be considered “like-kind” by the Internal Revenue Service (IRS) in order for capital gains taxes to be deferred.
- If/when 1031 exchanges are used properly, there is no limit to the frequency of 1031 exchanges.
- To qualify as a 1031 exchange, both properties involved must be located in the US because the US IRS rules apply.
Benefit of 1031 Exchanges
Since there is no limit on how many times investors can do a 1031 exchange, investors can roll over the gain from one investment property sale to another and another and another.
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Assuming the investor has a profit on each property swap, the investor avoids paying capital gains tax until that property is sold for cash many years later. Then, if everything works out as planned, the investor pays only one tax at a long-term capital gains of the last property sold. Currently, the capital gains rate is between 15-20%, depending on the investor’s income, or 0% for some lower income taxpayers.
We cannot suggest more strongly that you, your clients, agents, investors work with a tax specialist, tax attorney, etc. when considering and/or utilizing the benefits of a 1031 exchange regarding real estate.
What Does Like-Kind Properties Mean?
To qualify as a 1031 exchange, the investment/business properties involved must be like-kind. The rules stipulating how “like-kind” properties are defined are liberal – like-kind properties can be a small rental property and a large rental property, an apartment building for raw land or a ranch can be exchanged for a strip mall.
Defining “like-kind” properties is just one reason to work with a tax specialist/attorney.
An Example of a 1031 Exchange
Let’s say that your client owns an apartment building currently worth $2M, double what she paid for it six years ago. Your client is happy with the building until you, her real estate agent, tells her about a larger building in an area that generates higher rents and is listed for sale at $2.5M.
Using a 1031 exchange, your client could sell her building and then use the profits she earned from the sale of her $2M building to help her pay for the bigger, more expensive replacement property without having to worry about paying any immediate capital gains tax liability on that sale. Effectively, your client is able to use the “extra” money she would get from selling her first property to invest in the new property by deferring capital gains and depreciation taxes. Depreciation (wear and tear) calculations continue as if your client still owns the old property.
Hire a Professional!
Even if you, your client, your investor is a seasoned old pro with 1031 exchanges, 1031’s are complex structures with strict rules and strict timelines. Hire a fiduciary financial professional.
We’ve only scratched the surface regarding 1031 exchanges.
Hire a professional.
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