What is a 1031 Exchange in real estate investment?

If you are new to real estate investment or own investment property you must know about the 1031 exchange. This tax-deferred exchange is essential in buying and selling investment property. In a nutshell, the 1031 exchange involves a process that allows you as an investment property owner to buy a like-kind property while differing tax on capital gains.

Definition 1031 Exchange

The 1031 exchange has its name from Section 1031 of the United States Internal Revenue Code. It allows property owners to avoid paying taxes on capital gains to reinvest the profits from the sales into properties of equal or greater value.

Understanding 1031 Exchange

In real estate, a 1031 exchange can be simply considered as a swap of one property for another without paying capital gains taxes.

The 1031 exchange rule under section 1031 of the U.S. Internal Revenue Code states that proceeds received from the sale of any property are taxable unless the proceeds are transferred to a qualified intermediary. A qualified intermediary is an individual or company that qualifies to facilitate a 1031 exchange by holding funds involved in a transaction. The intermediary gets to hold the funds until they can be transferred to the seller of the ‘replacement property’.

Most property investors consider using a 1031 exchange for multiple reasons, such as:

• For assets diversification.

• Seeking a property with better return prospects.

• Securing an already managed property rather than personally managing one.

• To consolidate multiple properties into a single investment, or divide a single property into multiple assets.

• To avoid depreciation.

The major advantage of using a 1031 exchange rather than simply selling a property and buying another one is the tax deferral. With a 1031 exchange, you can defer capital gains tax, thereby, generating more capital to invest in the replacement property.

While a 1031 exchange may have its benefits, it also important to note that it requires a high investment and holding time. Therefore, it is more ideal for property owners or investors with higher net worth. Such transactions should also be handled by professionals due to their complexity.

The 1031 exchange rule involves only investment and business property, although, the rules may sometimes apply to a former primary residence under strict conditions.

Depreciation and 1031 Exchange

Depreciation plays an important role in appreciating and understanding the true benefits of a 1031 exchange. It is the percentage of the cost of an investment property written off each year, with the effects of wear and tear in view.

When an owner sells a property, capital gains taxes are calculated based on the net-adjusted basis of the property which shows the original purchase price, plus capital improvements, minus depreciation. If a property is sold above its depreciated value, then you can recapture the depreciation which will be included in your taxable income from the sale.