What's a 1031 Exchange?
For more than 100 years, U.S. tax law has let investors defer taxes on the gains from selling an investment property, as long as the proceeds are properly reinvested in "like-kind" property. This tax deferral is governed by Section 1031 of the Internal Revenue Code.
A 1031 exchange happens just like any normal real estate transaction, with two key differences: you must hire an independent third party, known as a Qualified Intermediary, to facilitate the exchange, and you may not take constructive receipt of your funds.
Don't Sell… Exchange!
Federal capital gains, state, investment income, alternative minimum and depreciation recapture taxes may all be deferred. It's like an interest-free loan that may never need repaying.
- With an exchange: $500,000 of equity stays $500,000 to reinvest, buying a $2.5M property at 20% down.
- Without an exchange: $65,000 of capital gains tax leaves $435,000, buying a $2.175M property.
- The difference: $325,000 more property, from the same equity.
The 5 Commandments of 1031 Exchanges
- 1: The property must be held for business or investment purposes.
- 2: To defer all tax, buy property of equal or greater value than the net selling price of the property you sell.
- 3: Within 45 days of closing your first transaction, identify up to three possible replacement properties in writing.
- 4: Complete both sides of the exchange within 180 days. The deadline is firm, even on a weekend or holiday.
- 5: Use a Qualified Intermediary to facilitate the exchange.
The Magic of Tax-Free Compounding
Start with $100,000 and make a 50% gain on each of 20 transactions. Exchanging each time grows your equity to about $332.5 million. Paying 30% tax each time leaves about $40.4 million. Same deals, same returns: the only difference is the 1031.
Every 1031 exchange is unique. This guide gives an overview of 1031 exchange requirements; always discuss your situation with a tax or legal advisor.
