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The Tax Benefits of 1031 Exchanges
By Isaac Franco
While taxes are always a sure thing, one way to defer them during the sale of an investment is with a 1031 Exchange. The 1031 Exchange is a beneficial investment strategy for the sale of investment property. It refers to the IRS federal tax code 1031 which states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
Typically, when a gain is made during the sale of investment property, the investor is subject to a capital gains tax. However, in a 1031 Exchange, the investor can defer taxes on any profit gained from the sale of their property until an investor is willing to recognize gain.
For a 1031 Exchange, an investor must find a “like kind” property, or one that is similar to usage and value. “Like Kind Property” is property of the same nature, character or class. Most real estate located in the US will be like kind to other real estate located in the US. (note real estate in the US is not like kind to real estate located outside the US).
Also, Business Property (equipment, furniture, automobiles) is not like kind property to real estate. A 1031 exchange company will help you identify like kind property.
To explain how a real estate transaction works with and without a 1031 exchange, let’s look at two transactions using Dan and Jim.
Example of a 1031 Exchange:
Dan has a buyer for his $1 million dollar apartment building and a $500 thousand dollar mortgage. Under the rules for the 1031 Exchange, he has 45 days to identify another piece of investment real estate and 180 days to complete the acquisition.
While Dan works to secure his new investment property, his money is held by a third party—usually a 1031 or “Starker Exchange” company.
Dan’s new property must have the same loan amount or higher, and be an investment property of the same net market value.
Within the 180 day purchase window, Dan closes on a piece of farmland valued at $2,000,000 with a $500,000 loan. Dan will not recognize gain on the sale of his Apartment building and was able to utilize all of the proceeds of his sale for the acquisition of his new farm.
In a 1031 Exchange, the tax is deferred until the property is sold without using the IRS section.
A Purchase Without the 1031 Exchange:
Similarly to Dan, Jim also sold a rental property, his condominium, for $1 million dollars that he had a $300,000 basis in (basis is the total costs paid in to acquire the property).
He decided to purchase a new piece of commercial real estate for $1 million, but did not do the 1031 Exchange. He was immediately subject to capital gains taxes on his $700,000 gain. The current top capital gains tax rate is 20 percent. Jim may have a $140,000 tax bill, which could have been better invested in the acquisition of the new property.
As you can see, 1031 Exchanges can be an advantageous way to sell and then purchase an investment property.
The real estate attorneys at Gardi, Haught, Fischer & Bhosale LTD are experienced with 1031 Exchanges and know if they are the best option for you. For more information, please contact us at 847-944-9400.
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