Real Estate Investment Tips on Tax-Deferred Exchanges (1031 Exchange)

A tax-deferred exchange is a where property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”. The payment of federal income taxes and some state taxes on the transaction is deferred until a later date, instead of a typical transaction where the property owner pays the taxes on any gain realized from the sale.  The exchange, however, is not tax-free.  When the replacement property is ultimately sold, the deferred gain as well as any additional gain realized is subject to tax.

Section 1031 of the Internal Revenue Code states “that no gain or loss is recognized on the exchange of property held for productive use where the property owner has reinvested the sale proceeds into another property.  For example, if vacant land is exchanged for an apartment building, the taxpayer could not be forced to pay taxes on “paper gain”.  The general guidelines to be met in order to allow the taxpayer to defer all taxable gain are that the value of, equity in, and debt on the replacement property must be equal or greater than the value of the relinquished property.  Also, all of the net proceeds from the sale of relinquished property must be used to acquire the replacement.”

The main reason to exchange property instead of selling is the ability to postpone taxes or potentially eliminate them all together.  That way you are able to use the money saved towards investing in another property, and you receive an interest free loan from the federal government in the amount you would have paid in taxes.

Before considering a tax-deferred exchange, there are a few requirements that allow for this replacement.  First, your property must qualify.  Properties that are specifically excluded are: inventories, stocks, bonds, or notes, properties held primarily for sale, interests in a partnership, certificates of trusts, and choses in action.  Also, both the relinquished and replacement property must be held for productive use in a trade or business investment.  Immediate resales or the taxpayer’s personal residence do not qualify.

Tax Deferred Exchange

For a deferred exchange, the properties must be of “like-kind”.  This means they must both be located in the U.S. and must qualify.  Personal properties must be of like-class.  It is also a basic requirement that the relinquished property must be directly exchanged for the other property and cannot be sold for cash to be used in purchasing the replacement property.

Tax-deferred exchanges can be very beneficial for the taxpayer planning to sell an investment or property.  As long as the IRS guidelines are strictly followed, this method can be used as a wise investment strategy. Avoiding losses potentially as high as 30% due to state and federal taxes means allowing the proceeds to go towards future investments or make improvements to the replacement property. If you are considering a tax-deferred exchange for your property, contact us if you are interested in this type of transaction!

For more information see: http://www.irs.gov/uac/Like-Kind-Exchanges-Under-IRC-Code-Section-1031

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