The 1031 exchange is one of the greatest wealth-building benefits for real estate investors.
Unfortunately, there are real estate owners who either have no idea of the existence of the 1031 exchange or, worse yet, they misunderstand the tremendous financial benefits of those benefits.
I've written this article to help overcome these problems.
What is a 1031 Exchange?
The term "1031 Exchange" refers to Section 1031 of the Internal Revenue Code.
In short, Internal Revenue Code Section 1031 allows the owner of a parcel of real estate that's being used either for business or as an investment to sell that property and to reinvest the profit from its sale - without paying federal income tax on that profit as long as they buy another property to replace the one they just sold in compliance with a few simple rules set down by the IRS. This is also called a "like-kind exchange."
And, while a 1031 like-kind exchange isn't limited to being used for real estate, this article will limited itself to the topic of real estate.
Types of Exchanges
There are four types of exchanges covered by Section 1031. They are:
1. The Delayed Exchange, which is the most commonly used where the exchanger first sells (relinquishes) their existing property then uses the profit from that sale to purchase their new (replacement) property.
2. The Reverse Exchange, which is the opposite process of the Delayed Exchange. It's when the exchanger first buys the new/replacement property before selling/relinquishing their existing property.
3. The Simultaneous Exchange, when both the closing of sale of the relinquished property and the closing of the purchase of the replacement property take place on the same day.
4. The Construction or Improvement Exchange. This is a relatively uncommon type of exchange. However, what happens is the exchanger sells the relinquished property, identifies the replacement property and transfers it to the Qualified Intermediary. The exchanger can then use the proceeds from the sale of the relinquished property to either construct or renovate/repair the replacement property. As you can imagine, there are additional conditions that must also be met.
Calculating Your Profit
Because federal capital gains income taxes are only charged based on the profit from the sale of your existing property, it's important to understand how to calculate that profit.
While the amount of profit will vary from property owner to property owner, in general, the profit is the amount that remains after deducting:
a) the cost basis (which is the amount you paid for the property and all qualifying costs to acquire the property),
b) capital improvement costs, and
c) the costs and expenses associated with the sale of the property.
Depreciation that may have been taken as an expense during your ownership must be recovered, or added to your original cost basis.
TAKE NOTE: The above list is only a general example. The profit associated with the sale of your specific property may include other deductions or additions.
I'm not a real estate investor; I don't own investment real estate.
If you own any type of real estate that's not your personal residence, whether you realize it or not, you are a real estate investor and that property is investment real estate.
It doesn't matter if it's a vacant building lot, an industrial building where you operate your business from, or any other type of real estate. If it's not your personal residence, it likely qualifies as investment real estate and you can benefit from the 1031 tax deferred exchange.
I don't know anyone to swap my property with.
When using the benefits of IRC 1031 you don't actually swap your property with someone else to get their property.
In this case, the term "exchange" is defined as selling one real estate investment property and replacing it by buying another real estate investment property.
You don't have to buy the same kind of property as the one you now own.
The term "like-kind" means you can sell any type of real investment estate and replace it with any other type of real estate because both are real estate.
For example, if you own an office building, you can sell it and replace it with a marina because both are real estate.
The Basic Rules
There are a few basic rules that apply to all types of 1031 exchanges and all rules must be followed in order to reap the benefits of the 1031 Exchange.
Be advised there is no flexibility when it comes to meeting the requirements of these rules. If you fail to follow them within the required time frames the profit from the sale of your existing property will be subject to the payment of federal capital gains income tax.
Rather than trying to list every rule associated with every type of 1031 exchange, I've provided this link to a thorough explanation of the required timelines, deadlines, and identifications required in the Delayed Exchange, which is the most common type of 1031 exchange.
Taking advantage of the extraordinary benefits of the 1031 tax deferred exchange is one of the wisest things a real estate investor can do to preserve and expand their equity and build wealth.
Contact us to discus the specifics of your potential 1031 exchange.