Why is the 1031 Exchange important to a real estate investor?
The preservation of wealth and assets is fundamental to the decision to exchange in that IRC Section 1031 allows the investor to exchange from one real estate investment property to another and defer taxes on the gain. In other words, a 1031 Exchange is a rollover of equity in like-kind properties, rather than an avoidance of tax. The result is the investor is able to continue to build equity through real estate investment. The other significant tax issue is through inheritance, the gains deferred along the way go away due to a stepped up basis rule in the estate tax rules. There could be estate taxes due, but not capital gain taxes. Basically, the taxes that were deferred are never paid.
Guidelines regarding the 1031 Exchange
- Taxpayer locates a buyer and sells the property through a Qualified Intermediary.
- Taxpayer identifies a replacement property and buys it through a Qualified Intermediary
- The parties may not know each other and their properties can be in different states.
- Taxpayer identifies suitable like-kind replacement property within the 45-day identification period which begins on the day the relinquished property is transferred.
- The exchange period begins on the day the relinquished property is transferred and ends on the earlier of 180 days thereafter or the due date (including extensions) of the tax return for the taxable year in which the transfer of the relinquished property occurs.
- The taxpayer’s agent, broker, attorney, accountant or family member is excluded as a qualified intermediary.
| CALCULATION EXAMPLE: | |||||
| Current Market Value | = $200,000 | ||||
| Mortgage | = $80,000 | $200,000 | Current Market Value | ||
| Equity | = $120,000 | -$150,000 | Original Purchase Price | ||
| Depreciation Taken | = $20,000 | +$20,000 | Depreciation | ||
| Taxble Gain on Sale | = $70,000 | $70,000 | Taxable Gain | ||
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| (A property can be sold for less than purchased for and still have a gain) | |||||
Without a properly executed 1031 Exchange:
Equity ($120,000) less tax ($21,000) = $99,000 available towards purchase of a new property.
With a properly executed 1031 Exchange:
If the tax-deferred exchange of the property was properly executed, TAX WILL BE DEFERRED and the investor will have $120,000 to use towards the purchase of another investment property.
The concept of a tax deferred exchange is easy to understand. However, there are many details involved in an exchange that need careful consideration. Before taking steps towards a 1031 tax-deferred exchange, please consult your CPA, attorney, or tax advisor.
