What is a 1031 Exchange?
A 1031 exchange is a tax strategy under Section 1031 of the internal revenue code that allows you to defer capital gains taxes on the sale of business and investment real estate. Taxes can be deferred when you exchange the real estate you are selling with another “like-kind” property.
Property exchanges originated as part of the Revenue Act of 1921. For many years the “exchange” referred to in the code was a true exchange. The owner of a property actually traded one property for another. It was difficult, however, to find two property owners of similar property to want to exchange their assets at exactly the same time. As a result, this type of swap was rarely used.
In 1954, Section 1031 of the internal revenue code was adopted, which further defined the nature of a tax-deferred “like-kind” exchange. Closing for the newly defined exchanges still needed to occur simultaneously, making it difficult to take advantage of the tax deferral benefit.
In 1979, a series of famous decisions by the courts in favor of TJ Starker and his family changed the nature of 1031 exchanges, by allowing that a delayed exchange was permissible under Section 1031 of the internal revenue code.
Today, property owners can wait up to six months before purchasing the replacement property without forfeiting the capital gains tax deferral. In order to safeguard the lawfulness of 1031 exchanges, the IRS put a number of regulations in place on the administration of delayed exchanges.
If the sale of the first property occurs before the subsequent like-kind purchase, the receipt of the funds must be handled through a qualified intermediary to ensure they are not used for other purposes during the wait. The qualified intermediaries also ensure that the exchange documentation is administered properly.
Once the question of what is a 1031 exchange is answered, it is easier to understand how it can help you maximize your real estate investments.
- You can use the value retained by deferring taxes to purchase a larger, more productive investment project. In this way, your investment portfolio can grow more quickly.
- You can replace poorly performing real estate assets, with income-producing properties
- You can more easily diversify your real estate portfolio, or change the product type to better follow the real estate market and your current interests
1031 tax exchanges are an excellent way to maximize your equity and grow your investment portfolio. At first look, the process may seem cumbersome and confusing. The safeguards put in place by the IRS ensure that the 1031 exchange is enforceable. The key to a successful transaction is to find a qualified intermediary who can help you every step of the way.