There’s been a lot of buzz about 1031 exchanges lately, but they are nothing new. Savvy real estate investors have been using them to defer taxes since 1921. It’s a common, fairly straightforward strategy that allows real estate investors to sell (or as the IRS calls it, “relinquish”) an investment property, while deferring capital gains taxes on the profit by reinvesting the proceeds in a “replacement” investment property. It’s arguably one of the most effective ways to build wealth, and a tool that every real estate investor should know about.
I do want to be clear: an exchange doesn’t eliminate taxes—it simply defers them to a later date. However, with some fairly simple estate planning, you can transfer properties to your heirs tax-free.
An exchange is also known as a “like-kind,” or "tax-deferred exchange." It gets its name from Title 26, section 1031, of the Internal Revenue Code, which says:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
The history of the exchange goes back to 1921, when the IRS allowed farmers to trade or exchange one piece of farmland for another. Today, the definition of like-kind real estate generally means "property held for investment." The IRS does not allow 1031 exchanges of a primary residence.
Several types of exchanges can be tailored to meet your investment objectives, including some unexpected examples for real estate. Interestingly, large companies and wealthy individuals often use non-real estate exchanges to “swap” aircrafts, art, oil, gas interests, and many other types of investments.
Many investors are also surprised to learn that federal capital gains tax is not the only tax liability they must face when selling real estate. There are also:
State Capital Gains Taxes (in some states)
Affordable Care Act Surtax
Depreciation Recapture Taxes
To put this in perspective, if you live or own a property in California, you could easily find yourself facing a combined tax rate in excess of 40% on your profit!
But an exchange may allow you to defer these taxes indefinitely—provided you reinvest your capital back into real estate.
Under existing tax laws you can avoid paying the taxes you’ve deferred forever through estate planning. The IRS allows subsequent exchanges each time a property is sold, which allows your equity to grow tax-free over time.
However, if you sell a property you purchased through an exchange—without a subsequent one—you will owe all the capital gains and depreciation recapture taxes that you have deferred though previous exchanges. But, combining an exchange strategy with another part of the tax code, known as a “step-up in basis,” allows your heirs to inherit the property tax-free. Yes, you read that correctly—with proper planning, all the taxes you deferred will never (ever) be due!
Wondering if you qualify for a 1031 exchange? It's imperative that you plan aheah before you sell your property,to ensure adherence to IRS rules and timelines. The common misconception is that it's different from a normal property sale, but usually it's not. If you don’t take certain steps before a property is sold, the option to do an exchange will not be available.
1031 exchange investing doesn't have to be difficult. That’s why we’ve created an investor guide that tackles the art and science of completing an exchange, and the pitfalls to avoid. What is a 1031 Exchange?features helpful charts, diagrams, timelines, and more. Get your copy today.
Realized1031.com is a website operated by Realized Technologies, LLC, a wholly owned subsidiary of Realized Holdings, Inc. (“Realized”). Equity securities offered on this website are offered exclusively through Thornhill Securities, Inc., a registered broker/dealer and member of FINRA/SIPC("Thornhill"). Investment advisory services are offered through Thornhill Securities, Inc. a registered investment adviser. Realized Holdings, Inc. has a minority ownership interest in Thornhill Securities, Inc. Check the background of this firm on FINRA's BrokerCheck.
Hypothetical example(s) are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment.
Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments are often sold by prospectus that discloses all risks, fees, and expenses. They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain and should not be deemed a complete investment program. The value of the investment may fall as well as rise and investors may get back less than they invested.
This site is published for residents of the United States who are accredited investors only. Registered Representatives and Investment Advisor Representatives may only conduct business with residents of the states and jurisdictions in which they are properly registered. Therefore, a response to a request for information may be delayed until appropriate registration is obtained or exemption from registration is determined. Not all of services referenced on this site are available in every state and through every representative listed. For additional information, please contact 877-797-1031 or firstname.lastname@example.org.