1031 Exchange – What It Is, How It Works, And Why It Matters

We previously discussed the Tax Benefits of Home Ownership that relate primarily to principal residences, but what about tax benefits or advantages of investment properties?  In real estate, investors often take advantage of what is commonly called a “1031 Exchange” in order to defer tax liability on gains when selling an investment property.  In this article we discuss the ins and outs of a 1031 Exchange.

What Is A 1031 Exchange?

A 1031 Exchange, also known as a “like kind exchange”, derives its name from Internal Revenue Code Section 1031, which provides that “no gain or loss shall be recognized” on the exchange of a property used in trade or business if the property is exchanged “solely for property of like kind” which is also to be used in trade or business.

So what does this mean?  By way of example, let’s imagine Xavier purchased an investment property in the year 2000 for $500,000.00.  This year he would like to sell the property, and believes the property is worth $750,000.00.  This means he will potentially have to realize, and pay tax on, a gain of $250,000.00.  However, after selling the property, Xavier intends to acquire a different investment property with the $750,000.00 he will receive from the sale of the first property.  Section 1031 provides that because the original property is being used “in trade or business”, and because it is being “exchanged” for a “property of like kind” that is also to be used “in trade or in business”, Xavier does not need to recognize the $250,000.00 gain on the sale.  Instead, the cost basis of $500,000.00 from the old property carries over to the new property, and Xavier will not have to recognize the gain until he sells the new property.

Stated simply, a 1031 Exchange allows business property to be exchanged for other business property without immediately realizing the built-in gain on the original property.

How Does A 1031 Exchange Work?

Property owners need to move quickly in order to qualify for a 1031 Exchange.  First, after the original property is sold, the new property must be identified within 45 days.  In order for this requirement to be satisfied, the identification must clearly describe the replacement property, it must be in signed writing, and it must be delivered to the seller of the new property.  In other words, a written offer needs to be made on the replacement property.  Second, the new property must be received and the exchange completed no more than either 180 days after the sale of the original property or the due date of the tax return for the year in which the original property was sold, whichever happens earlier.  If these two requirements are met, then the transaction can qualify as a 1031 Exchange.

Why Does This Matter?

IRC Section 1031 is meant to encourage the sale of business properties and assets in exchange for potentially newer or better properties and assets, without immediately paying tax on built-in gains.  It is important, particularly in real estate, because it is a vehicle that allows investors to capitalize on the benefits of appreciation without paying tax.  For example, looking back at Xavier, let’s assume his rental income on the original property he purchased for $500,000.00 is $2,000.00 per month.  His new property that he acquired after a 1031 Exchange for $750,000.00, however, is much larger and nicer.  As a result, Xavier’s rental income is now $3,000.00 per month.  The 1031 Exchange allowed Xavier to increase his investment’s return while deferring the tax on the value of his investment.

If used properly, a 1031 Exchange is a powerful tool that investors should fully understand.

Note that this article is not intended to be, nor should it be construed as or relied upon as, tax advice.  Please contact your tax consultant to discuss whether your transaction will qualify as a 1031 Exchange

If you would like to further discuss how Esquire Real Estate Brokerage, Inc. can help you in the Los Angeles real estate market, feel free to give us a call at 213-973-9439 or send us an email at info@esquirereb.com