The 1031 Tax Exchange is a section in the U.S. Internal Revenue Service Code which allows investors to postpone capital gains taxes during an exchange of like-kind properties for investment or business purposes. Thus, capital gains or taxes are not imposed on a property sold if the net equity plus debt retired is used to buy another property of equal or greater value. Tax payment is deferred until such time that the replacement property is sold without initiating another 1031 exchange.
The 1031 Exchange Explained
A 1031 exchange is when a person or business sells a property to buy another – no gain or loss is recognized, just a transfer of property. For example, an investor sells building A to buy building B. The federal and state capital gain and recaptured depreciation tax triggered on the sale of building A is deferred indefinitely given building B is acquired in a 1031 exchange. The tax is not due because the investor does not receive any benefits such as cash or less debt than before the sale of building A. When the replacement property is sold, the tax is due unless another 1031 exchange is effected.
Replacement Property Advantages
The 1031 tax exchange allows easy replacement of assets without the need to pay for immediate taxes, which can result in an interest-free loan to be used towards acquiring a replacement property. In this way, the 1031 tax exchange makes sense because the individual or business may use the selling and buying of properties in their businesses, such as highway construction equipment, business aircraft, farmland, MRI hospital equipment or a vacation rental property. The reason for the selling and buying may vary. A practical example is that the taxpayer wants to have his properties closer to where he lives so he can oversee them.
1031 Exchange Benefits
Increases working capital– Capital gains income tax from property sales can be as high as 35 percent or more. Without the 1031 tax exchange, tax liabilities from real property sales can reduce the investor’s equity, which impacts his ability to build net worth by buying more and bigger properties.
Renewed Depreciation Schedule – The replacement property depreciation schedule starts with a full depreciation life to offset future income. The 1031 exchange allows a property with a shorter or diminished depreciation schedule to be replaced with a new schedule.
Realign Investment Strategies – The 1031 tax exchange allows the investor to replace an investment property that is less efficient for one that generates cash flow, such as land for a vacation rental. Timberland REITs use 1031 exchanges to realign less productive timber with timberland tracts that match their investment strategy.
Swap Until He Drops– The 1031 exchanges are recognized as an excellent wealth building tool. Investors who build their net worth and cash flow over a lifetime of investments will typically gain more than the person who pays taxes as he goes. It is called “Swap Until He Drops”.
1031 Tax Exchange Facts
An investor can qualify for the 1031 exchange by following specific rules.
Every kind of real property is considered “like kind” and can be exchanged for other real estate. For example, one can exchange a vacant land for apartments or a rental house for a shopping center, as long as they are for business or investment use. Personal use must be no greater than 14 overnights per year or 10 percent of the yearly rental.
The investor does not need to spend all of his funds from the property sold. However, any unspent amount is considered cash boot and subject to taxes. An example of this is when the investor sells building A for $1 million to buy building B for $700,000. The remaining $300,000 is the cash or equity boot and is taxable. Cash offsets debt, but debt does not offset cash.
Learn more about when a 1031 exchange makes sense by clicking on the button below to download “Ten Reasons Why a 1031 Exchange Makes Sense.”
