Things You Need to Know About Tax-Deferred Real Estate Exchanges

Posted: 8/20/2013

Ok so first things first: What exactly are 1031 tax deferred real estate exchanges? Well, it's not common knowledge but under section 1031 of the Internal Revenue Code, property owners are allowed to sell appreciated investment real estate (or personal property), reinvest the proceeds in the ownership of like-kind property then defer payment of their capital gains taxes. In other words, they allow you to keep 100% of your equity invested and working rather than losing roughly one-third of your equity to tax debt. Of course there are a set of pretty darn specific requirements that need to be followed in order for a property sale to qualify for 1031 Tax Deferred Exchange status under Section 1031 of the tax code. To begin with, to qualify as a "like-kind" exchange, the real estate transaction in question will have to be completed in accordance with the rules set forth by the IRS and in relevant the treasury regulations. But they're worth the effort, 1031 exchanges offer tax advantages galore to real estate investors. Though underutilized the 1031 exchange is quite frankly one of the Internal Revenue Code's best-kept secrets.

Making use of it allows you to change the nature of an investment without realizing anything that the IRS recognizes as capital gain. Such investment can continue to grow tax deferred and there's basically no limit on how frequently or how many times you can use 1031s. You can literally roll over the gain from one investment property to another to another then another. And you can realize a profit on each 1031 swap, avoiding associated tax liabilities until you actually sell the property for cash ... Whereupon you'll most likely only be taxed at the long-term capital gains rate. Now, here's the inevitable catch you've been waiting for me to explain: There are special rules that apply whenever a depreciable property is exchanged via a 1031. For instance; using an exchange may trigger what's known as "depreciation recapture" gain that will taxed as if it were ordinary everyday income. That works like this:

If you were to exchange a rental property worth $150,000 for which you took depreciation deductions totally $40,000 for a property worth, $150,000 the $40,000 in depreciation deductions you claimed will be considered ordinary income. That doesn't mean that 1031 exchanges are potentially more trouble than they're worth, but it does mean that you'll almost certainly need an assist from a professional if you're going to attempt one. Not only because the process of managing a 1031 is the exact opposite of uncomplicated, but also because they aren't intended for "personal" use. The provision is only applies to investment or business properties. In other words you won't be able to swap your primary residence for your vacation home.

Should You Really Be Considering a 1031 Like-Kind Exchange?

The short answer is maybe. If you own an investment property or a piece of business related real estate, that's either substantially depreciated for tax purposes or has notably appreciated in terms of its fair market value, you're someone who might want to consider taking advantage of a 1031 tax deferred exchange. But again, the process is littered with traps for the uninitiated. Starting with the way the official definition of "like-kind" is simultaneously the key to the entire process, notoriously vague and intentionally broad.

You can exchange a condominium complex for an empty lot ready for development or a shopping mall for an office building or one industrial building for another industrial building. So if you're interested in upgrading or consolidating your applicable property holdings or deferring your capital gains taxes a properly structured like-kind exchange can offer you the tools to do so. With the help of a qualified 1031 Exchange Facilitator you can get what is essentially an interest-free, no-term, government loan.

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