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.