The Benefits of a 1031 Tax Exchange

THE CURRENT REAL ESTATE CRAZE of flipping homes and other properties, buying for the purpose of selling for a profit, has stoked new interest in an underutilized financial tool that has been available to investors for nearly a century.

Investors both current and prospective should take a good, hard look at Section 1031 of the Internal Revenue Code and consider a 1031 exchange, a once little-known but now increasingly popular way to keep from giving money to the government–at least temporarily.

The 1031 exchange has been part of the IRS Code since 1921, but it was all but dormant until an awakening in the 1990s. The concept behind this tax-deferred exchange is that an investor can transfer the equity in one property to a new property and basically maintain the same investment with a different asset.

As long as all proceeds from the sale are invested in the new property, the IRS actually considers the deal to be one continuous investment. As a result, no capital gains tax is due on the profit from the sale of the relinquished asset.

A 1031 exchange is especially useful for investors who buy and renovate properties and subsequently reinvest the profits in more valuable real estate.

A 1031 exchange is an extremely powerful tool for investors seeking to increase the size of their real estate holdings. Being able to transfer equity into more valuable properties without having to pay a tax bill is the pot of gold at the end of the rainbow for those who know where to look.

Investors must remember that in a 1031 exchange, their capital gains tax is deferred but not eliminated. If you sell your property during your lifetime and do not qualify for a tax-deferred exchange, you will have to pay taxes both on the capital gains and the recapture of the total depreciation taken during the original investment.

As with any dealings with the IRS, there are rules for the 1031 exchange:

• The relinquished property and the replacement property must both be investment real estate properties located in the United States–and your personal residence cannot be involved in the deal.

• The real estate investor must trade only “like kind” real estate–properties that are similar in nature or character.

• The new property must be worth more than the old property, both in value and equity.

• A neutral third party, commonly called a facilitator or a qualified intermediary, should be involved in the transaction. This person takes possession of the proceeds from the sale of the property, uses the funds to purchase the new property, then transfers title of the property to the investor.

• The replacement property must be clearly identified in writing within 45 days of the closing of the relinquished property.

• The closing for the replacement property must occur within 180 days of the closing of the relinquished property.

With such an attractive option available for real estate entrepreneurs, both seasoned and novice, an increasing number of savvy investors are already taking advantage of the 1031 exchange. More will soon follow suit.