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The Truth About 1031 Exchanges

A 1031 Exchange is a method by which a property owner “trades” one property (“relinquished property”) for another of equal or greater value (“replacement property”) without having to pay any taxes on the transaction. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property. In a 1031 Exchange, however, the capital gains tax on the transaction is deferred until some time in the future, usually when the newly acquired property is sold.

A 1031 Exchange is an investment strategy that should be considered by anyone who owns appreciated investment or commercial real estate. These exchanges are sometimes called “tax–free exchanges,” because the exchange transaction itself is not taxed. If the transaction is properly documented and coordinated, a delay of up to six months between the sale of the relinquished property and the purchase of the replacement property is permitted.

In order for a transaction to qualify for section 1031 treatment, three primary requirements must be satisfied: (1) there must be an exchange; (2) the property must be “trade or business or investment property”, and (3) the property must be of “like-kind.” Some of the Pros and Cons of the 1031 Exchange are:

Pros:

  • Capital Gains Taxes and depreciation recapture from the sale are deferred
  • The exchanger has more money to reinvest in replacement property
  • Because the exchanger’s heirs receive a stepped up basis (Fair Market Value at Date of Death), exchanges can be attractive estate planning tools.

Cons:

  • The exchanger may feel compelled to identify and acquire unsuitable replacement property solely to realize the exchange tax savings
  • An exchange usually results in additional transaction costs, including attorney/CPA fees and qualified intermediary fees. However, in most instances, the tax savings from the exchange easily offset these costs.

If you do it right, a 1031 Exchange can provide substantial benefits to those looking to buy and sell investment or commercial property. Of course, if you do it wrong, you could be left with a huge tax burden thinking that you’ve avoided that liability all along. At least for now though, the IRS lets you buy and sell investment or commercial property without current tax liability as long as you follow the proper procedural requirements.