A 1031 exchange is a way of deferring capital gains taxes on the sale of real estate. Taxpayers who sell property held for investment purposes can defer the taxes by directing the proceeds from the sale into "like-kind" property of the same or greater value, also to be used for investment. In practice, almost any investment property has been considered “like-kind” by the IRS.
Ever since the 1031 exchange was introduced through the Revenue Act of 1921, swapping like-kind property held for investment or trade has been successfully used to help defer capital gains taxes. But over the years, questions have arisen about property that is eligible for exchange.
If you’ve been following our blogs on a regular basis, you know that the 1031 exchange allows investors to “swap” real property used for trade or investment into other real estate of equal or greater value. The benefits of the like-kind exchange include the ability to “trade up” into another property and to defer capital gains taxes while doing so.
Seller Refinancing and 1031 Exchanges
The 26 U.S. Code § 1031 is relatively straightforward. Identified as “Exchange of Real Property Held for Productive Use or Investment,” the process focuses on disposing of an owned piece of real estate (i.e., the "relinquished” property) and swapping the proceeds into another real estate asset (i.e., the “replacement” property).
According to Benjamin Franklin, the only thing certain is death and taxes. And, when it comes to owning real estate as an investment, taxes are definitely certain. In addition to property taxes and taxes on earned income, capital gains taxes must be paid when the asset is sold (assuming, of course, that it is sold at a profit).
A 1031 exchange refers to Section 1031 of the Internal Revenue Code, which allows taxpayers to defer the recognition of capital gains taxes which would otherwise be due from selling investment property if the investor replaces the sold property with a “like-kind” asset of the same or higher value. At the outset, this exchange was a real-time event (and it was possible to transact using other assets in addition to real estate), but over time it has developed such that most exchanges transpire on a delayed basis. As a result, protocols need to be in place to ensure that the taxpayer doesn't control the proceeds from the sale of the property they are relinquishing during the time before the purchase of the replacement.
In a 1031 exchange, capital gains taxes can sometimes be deferred when selling one investment property and using the funds from the sale to purchase a like-kind replacement property.
Real estate investors often swap one property for another through 1031 exchanges. By completing exchanges, investors avoid generating a taxable event from the sale of their original properties.
Real estate investors have long turned to 1031 exchanges to defer capital gains taxes on the sale of investment properties.
Real estate investors who sell investment properties will have to pay significant capital gains taxes on the sale proceeds unless they reinvest those funds into a similar replacement asset.