A 1031 Exchange Offers Investors Options for Deferring Capital Gains Taxes

Written by admin on May 22nd, 2011

A tax deferred exchange or 1031 exchange is a strategy or tool that can be used by an investor to sell property, as long as it qualifies, and then buy another like-kind property.  Since the transaction is treated as an exchange rather than a sale, investors qualify for a deferred gain.  The law can be found in U.S. CODE: Title 26, §1031, Exchange of Property Held for Productive Use or Investment, but it can be summed up by saying that sales are taxable and 1031 exchanges are not.

Section 1031 of the IRS code recognizes transactions or exchanges which allows deferment of capital gains taxes.  Therefore, it is crucial to understand the elements involved and the underlying intent in this tax deferred exchange.  The U.S. Treasury Department has interpreted the like-kind exchange regulation under 1031.  This has led to generally accepted practices, standards, rules and compliance in order for a successful transaction to qualify and be completed. 

Investors who are familiar with real estate transactions know that capital gains can run anywhere from 20-30%, depending on state and federal tax rates.  Therefore, you sell a property which has appreciated from 100,000 dollars to 350,000 dollars over the period you have owned it, you would have a 0,000 capital gain tax liability.  This means that you would have from ,000 to ,000 less if you sell a property and then buy another without the benefit of section 1031.

There are some things you should know about 1031 exchanges.  You will have to go by strict timelines regarding identification (45 days) and exchange (180 days) periods.  These days are counted even if the last day of the time period falls on a weekend or nationally recognized holiday.  The purchase price of the replacement property must be equal to or greater than the total net sales of the property you are selling.  If the purchase price is less, then any money that is left over is taxable under IRS rules.  All of the proceeds must be used to purchase a like-kind, replacement real estate property.  If these rules are contravened, tax liability accrues to the one who executes the 1031 exchange.

Sale proceeds are also strictly controlled and they must go through a qualified intermediary (QI) and not the investor or the investor’s agent.  If this is not observed, then the entire proceeds become taxable under section 1031.

Having so many rules and strict guidelines and timelines may seem like too much trouble, but it is not really so if you consider that you can actually save tens of thousands of dollars in capital gains taxes.  1031 exchanges allow you to make real estate investments and defer capital gains taxes until sometime in the future.  By having this option, you are not bound by the typical, buy sell then buy again formula that is generally used in real estate.  You can actually increase your real estate holdings and investments quite handsomely by using something that the IRS considers a perfectly legitimate way to conduct a real estate transaction.  As long as you stay keenly aware of the rules and the timelines, you might find that a 1031 transaction is just right for you.

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