What is a 1031 Exchange?
1031 Exchange Basics
Taxes might be an unavoidable part of life, but there are intelligent ways for you to better leverage the taxes you owe to your advantage. With a 1031 exchange, you can maximize your investment potential by deferring certain taxes and increasing the size of your next investment. Learn more about how it works.
What is a 1031 Exchange?
A 1031 exchange lets real estate investors defer taxes, both capital gains and depreciation recapture, when they sell an investment property. To qualify for tax deferral, the investor must reinvest into a new investment property (hence the term “exchange”). Moreover, the new asset — or assets — must be “like-kind” replacement property, and the replacement should be of equal or greater value than the older, relinquished property. Essentially, you trade one property for another to qualify for what the IRS terms “nonrecognition of gain or loss.”
In short, the IRS says “As long as you keep using real estate productively, we’re not going to punish you by levying taxes.”
This exchange strategy gets its name from Section 1031 in the Internal Revenue Code. And, in practical terms, a 1031 exchange can be a very powerful tool for building wealth. Whether you’re just beginning to explore real estate investing or have been doing it for years, understanding how to 1031 exchange is key to maximizing your profit and wealth.
Note that executing a 1031 exchange isn’t a DIY project. To comply with IRS rules, you need a middleman called a Qualified Intermediary (QI) if you want to enjoy the tax deferral benefits.
Let’s take a closer look and explain the 1031 process:
Imagine this: You purchase a rental property for $300,000. Ten years later, you sell the property for $500,000. This represents a potential taxable capital gain of $200,000, plus you have 10 years of depreciation recapture taxes to deal with. Without utilizing a 1031 exchange, you would likely end up writing a very large check to Uncle Sam (and your state government). But, thanks to using the 1031 exchange strategy, you are able to defer your capital gains tax and recaptured depreciation taxes and reinvest all of your built-up capital.
And here’s the key: Deferring taxes allows you to deploy your wealth more efficiently. You can use the funds that would have gone towards taxes as part of the down payment on the next property. With a bigger down payment, you can afford more, more expensive and/or higher quality properties. In turn, those properties most likely have a higher income-producing potential. You can also switch property classes or invest in a different part of the real estate sector.
Steven W. Hickox, the founder of 1031X, describes the 1031 exchange process as “an interest-free loan from the government.” The extra money that you have access to if you qualify for a 1031 makes a significant difference in your investing decisions. It also dramatically affects your cash returns and can transform your portfolio throughout your investing career.