What is 1031 Exchange
What is a 1031 exchange? In brief, a 1031 exchange allows for the deferral of capital gains and depreciation recapture of real property if held for trade, business or investment purposes and reinvested into “like kind” property. Internal Revenue Code §1031 represents the ability to defer federal capital gains and recaptured depreciation taxes when selling real property held for investment or in the production of income or in a business and replacing with real property that is also held for investment or in the production of income or in a business.
By deferring the tax, the Exchanger is able to use the tax deferred as additional capital towards the purchase of more real property. Rather than paying the tax which is then deferred until the sale of the replacement property, the gain or the dollars it represents can be used to purchase a greater value of property, thus maximizing the marginal use of each taxable dollar.
Ok, so what does this mean? Let’s look at this example rental property purchased for $50,000 with a $25,000 loan and later after ten years sold for $150,000. The structure is valued at $25,000 and was depreciated each year, totalling $9,091. Selling expenses include realtor sales commission, title insurance and other associated closing expenses of $13,500. The total capital gain is $95,591.
If a 1031 exchange is initiated, the total tax deferred is $15,248 (recaptured depreciation of $2,273 + federal capital gain of $12,975). Rather than exiting the closing with after tax equity of $96,252, initiate a 1031 exchange reinvesting $150,000 or more in the replacement property and allow the $15,248 to continue to work in your interest. Effectively, the 1031 is an interest free loan of $15,248, allowing a cash infusion to fund new opportunities.
Types of 1031 Exchanges
There are multiple types of exchanges that exist, some differing in sequence and others differing in what is accomplished. The most common type of 1031 exchange is a “Forward,” or “Delayed Exchange,” that involves two properties. Typically, the taxpayer will sell or “relinquish” their investment property and then “replace” the property within the 180-day exchange period. It is also possible to purchase your “replacement” property prior to selling your “relinquished” property; this is called a “Reverse Exchange.”
Less common are International exchanges, or exchanges outside of the US, Build-to-Suit exchanges where the proceeds of the relinquished property are used for improvements on land purchased, and finally Leasehold Improvement exchanges where the proceeds of the sold relinquished property are utilized to improve land that is already held by the taxpayer.
Forward Exchange – The taxpayer sells their property and then replaces with another property.
Reverse Exchange – The taxpayer purchases the replacement property prior to selling their property. This is achieved by utilizing an EAT “Exchange Accommodator Titleholder.”
International Exchange – Property outside of the United States (excluding Guam, The Virgin Islands and Puerto Rico) is exchanged with other property located outside of the United States.
Build-to-Suit Exchange – The taxpayer sells their property and identifies a parcel of land and utilizes the exchange funds to improve the land within the 180-day exchange period.
Leasehold Improvement Exchange – Similar to a Build to Suit Exchange, the proceeds of the relinquished property are utilized to improve property already owned by the taxpayer.
Is a 1031 exchange complicated? We often get asked this question in consultations. There are very clear 1031 exchange rules and requirements that must be followed; experience in accommodating exchanges is essential in knowing how to execute properly.