How to use 1031 Exchange?

A 1031, or Tax Deferred Exchange, allows a property owner to sell a property and then directly buy another property over a period of time. The name comes from the fact that the transaction is an exchange and not just a simple sale. In this process, the taxpayer is entitled to a deferred gain because real estate sales are taxed by the IRS but 1031 exchanges are not. A 1031 exchange is recognized by the IRS as a means of deferring capital gains taxes. Therefore, it is important that you understand what is involved, what the rules are, and what the underlying intent is before you can think about going ahead with it.

Any property owner looking to acquire a replacement property “like kind” should consider a 1031 exchange before the existing property is sold. A property sale would incur a capital gains tax of 15 percent at current rates, but this could be as high as 30 percent after including federal and state taxes. By doing a 1031 exchange, you can bypass this until your property is sold for cash.

Capital real estate investment is depreciated at 3 percent per year on the condition that you hold the investment until it is fully depreciated. When you sell the property, the IRS will tax you on the portion that was written off as income tax.

There are two basic rules that must be followed in conjunction with other regulations established by the IRS for a 1031 exchange. The first rule is that the total price of the “same type” replacement property must be equal to or greater than the total net sales of the abandoned property. The second rule states that all equity acquired through the sale of the abandoned property must be used to acquire the new “like kind” property. If the value of the purchased property decreases, the difference is taxed.

Failure to comply with any of these rules will result in a tax liability for the person making the 1031 exchange. If the replacement property is of lesser value than the property purchased, the individual becomes liable for tax. Even if not all of the equity is transferred, the like-kind property tax rules apply. Partial exchanges can also be carried out, which are usually also eligible for a partial tax deferral.

Only a Qualified Intermediary (QI) may administer the proceeds from the sale of the original property, otherwise all proceeds are considered taxable. The entire amount acquired on sale must be invested in the purchase of a new property and if any cash is withheld from the proceeds this is taxable. It’s also important to note that this doesn’t just apply to cash. Even if you don’t physically receive the cash, but your liability for the property you purchased decreases, you will still be taxed.