What is a 1031 exchange and how does it build wealth?
Often called a 1031 tax free exchange, a 1031 tax deferred exchange, or even a 1031 exchange real estate, the term “1031 exchange” refers to Internal Revenue Code Section 1031 (IRC 1031) which; states:
“No gain or loss shall be recognized on the exchange of property held for…investment if such property is exchanged solely for property of like kind which is to be held…for investment.”
In a nutshell*, this means an investor can avoid the drain of capital gains taxes when selling an investment property by simply purchasing another investment property of equal or greater value if he does so under the rules of a 1031 tax free exchange.
(*The tax code includes all properties held for productive use in a trade or business, but we are real estate professionals so our discussion will be limited to real estate properties held for investment purposes. See our Resources page for the actual tax code governing 1031 tax free exchanges and 1031 tax deferred exchanges. The detailed tax regulations for 1031 exchanges are also available from the Resource page. )
A 1031 exchange should be considered by anyone who owns investment property.
Executing a 1031 tax free exchange can be simple and the tax savings are significant. In the following example a property originally purchased for $600,000 is sold for $1,100,000 for a gain of $500,000. A 1031 exchange defers the tax of $120,000 that would normally be handed over to the IRS, leaving the entire $500,000 gain in the hands of the investor as cash to reinvest.
|Cash to Reinvest||$380,000||$500,000|
Our example is simplified, but please use our capital gains calculator to investigate the tax impact on selling property you currently own. You work too hard to simply pay the tax without carefully considering the benefits of a 1031 tax free exchange.
A few 1031 exchange terms & definitions
1. Relinquished Property: Property that has been sold, usually in anticipation of purchasing a property of equal or greater value in a 1031 like kind exchange.
2. Replacement Property: An investment property purchased to replace a previously sold (relinquished) property as part of a 1031 property exchange.
3. Exchange Period (180 days): The investor must purchase the replacement property within 180 calendar days of selling the relinquished property, (in a reverse exchange, the investor can start by purchasing the “replacement property” then sell the original investment property within 180 days).
4. Identification Period (45 days): The investor must identify candidate replacement properties within 45 days of selling his original investment (relinquished) property.
5. Like Kind: To qualify as a 1031 exchange the relinquished and replacement properties must be of “like kind.” For real estate investors that simply means both must be investment properties: raw land can replace an apartment building, a warehouse can replace a Blockbuster or Family Dollar retail outlet.
Some basic rules:
- Reinvest all relinquished property sales proceeds into the replacement property
- Replacement property must have equal or greater market value than the relinquished property
- Properties exchanged must qualify as “like-kind”
- Strictly adhere to time requirements
|Meets equity requirement||Fails equity requirement|