DISCLAIMER: You are advised to contact your tax consultant regarding tax matters. The information provided here is for your general knowledge about your options relating to real estate investments.

WHAT IS A 1031 EXCHANGE?  

Internal Revenue Code Section 1031 provides that no gain or loss will be recognized on the exchange of any type of business use or investment property for any other business use or investment property. 1031 Exchanges are not really exchanges in the context of two-party barter. Instead, they are typical sales and purchases that involve the same exact ingredients as any other sale or purchase, without the capital gains. The only real difference is the investor is increasing his selling and buying power by electing to avoid the drain of taxes under Section 1031 regulations.
No other aspects of the transaction are affected.

WHO SHOULD CONSIDER A 1031-EXCHANGE?

Anyone who is thinking about selling a business use or investment property should consider affecting a 1031 Exchanges. An Exchange offers the astute investor an opportunity to reinvest the federal capital gains that would normally be handed over to the IRS and put that money to work for himself. You work too hard to simply pay the tax without carefully considering this reinvestment option. Essentially, 1031 Exchanges should be thought of as an interest free loan from the IRS; one in which the principal may be increased through subsequent exchanges and may never require repayment, if you plan properly.

MISCONCEPTIONS ABOUT EXCHANGING

  1. Many still believe that you must “Swap” 1031 properties. Although this was required in the original code, this is rarely done in present times. Exchanges now enable one to sell their property to someone totally unrelated to the person from whom they are purchasing their replacement.
  2. Many believe only investors of large commercial properties can utilize the benefits of Section 1031. The great thing about 1031 Exchanges is that it applies to all investment properties, large and small. It will work the same way for a corporation selling a large shopping center as it would for an individual selling a single-family home used as a rental property in a vacation area.
  3. Many believe you must acquire a property of "similar use or service." While exchanges are also known as 1031 "like-kind" exchanges, like-kind simply applies to real property held for business use or investment. Therefore, an investor may sell raw land and acquire a five-unit apartment building or sell a warehouse and acquire raw land. He can sell one property and acquire three or sell four and acquire one. Virtually any type of real property used for business use or investment will qualify.
  4. Many believe exchanges 1031 are very complicated and not worth doing. The fact is that when working with a qualified intermediary who specializes in Section 1031 tax deferred exchanges, the exchange process is very simple. The intermediary will keep you aware of your time deadlines and ensure you do everything in strict compliance with IRS regulations.

ADVANTAGES OF EXCHANGING

  1. The 1031 Exchanger will have more buying power because the federal income taxes are deferred. This will enable him to leverage himself up greater than he could have he paid the tax liability. The additional equity to reinvest will make him a more solid buyer and help him get easier financing.
  2. Investors can do exchange after exchange to create a pyramiding effect. This tax liability is forgiven upon the death of the investor as the heirs get a stepped up basis on the inherited property.
  3. The Exchanger will have greater selling power because he does not have to inflate the sales price to try to cover some of the capital gains that would normally be due upon the sale of an investment property. It will enable him to be more flexible with the selling price.
  4. The Exchanger can acquire a replacement property with greater income potential. He can sell raw land and acquire income-producing property. Perhaps, he wants to acquire a building with additional units or in an easier to rent location.
  5. The Exchanger has the opportunity to consolidate several hard to manage properties in one easy to manage property or diversify several small properties into one large property. It provides an excellent opportunity to relocate or expand a current business or investment.
  6. An exchange can also help an investor acquire a less management intense property.

BESIDES TAX REDUCTION,
1031 EXCHANGES CAN ACCOMPLISH MANY INVESTMENT GOALS:

All of the above culminates into one significant power-The ability to create pyramiding wealth accumulation in real estate ownership. 

SLIGHT DISADVANTAGE

The basis of your replacement property will be lowered by the amount of gain deferred on the sale of your relinquished property. However, when weighing this against the deferred gain, the astute investor can clearly see he is still significantly ahead.

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