The 1031 Tax Exchange

There is more to amassing wealth than simply increasing your spendable income. Ask every wealthy person that you can find, and virtually all of them will tell you that a major cornerstone of their fortune has been the implementation of an effective tax-saving strategy plan. For real estate investors, the 1031 tax exchange is a powerful method of deferring taxes from the sale of real property.

The 1031 tax exchange gets its name from Section 1031 of the U.S. Tax Code which regulates the procedure and, when done correctly, allows for the deferment of capital gains taxes. Generally, if you exchange business or investment property for other like-kind property, then no gain or loss is recognized for tax purposes. If, as a part of the exchange, other property is received that is not of like-kind (also known as boot), gain is recognized for taxation purposes based on the value of the other property and/or money received. Any loss, however, is not recognized. The rule of thumb, then, is to exchange real property for similar real property.

Properties are considered to be like-kind if they are similar in nature or character, even if they differ in quality or grade. Real property is generally considered to be like-kind, as long as it is business or investment property. Therefore, a personal residence could not be a part of a 1031 exchange. The proceeds of one property can be used to purchase a single or multiple properties, or vice versa; the proceeds from the sale of an office building, however, may not be used to buy a personal home without the levying of capital gains.

A 1031 tax exchange requires the use of a third-party entity, also known as a qualified intermediary. This entity performs the same duty as an escrow company, but only where the exchanging of money is concerned. When a property is sold, the funds from the sale are transferred directly to the qualified intermediary. The intermediary then uses the funds to purchase the property which completes the exchange. Any unused funds become subject to capital gains taxes.

The IRS imposes strict time limits on the completion of 1031 exchanges. From the date of sale of your original property, you have 45 days to identify a new property or properties and provide written notice to the qualified intermediary. Once identified, you then have 180 days from the date of sale of the original property to close on the new property. The IRS is very rigid with these deadlines. There are numerous other guidelines which the IRS imposes on 1031 exchanges that must also be adhered to.

A 1031 tax exchange is a very effective way to defer taxes. By using it, you essentially get to use your would-be tax dollars to continue to fund your wealth-building investment activities. It allows you to essentially compound your profits and the growth of your real estate investment portfolio tax-free. You must, however, be extremely careful to adhere to all of the rules governing this procedure. The use of a qualified tax professional, experienced in 1031 exchanges, is highly recommended.