Understanding A 1031 Property Exchange

Posted on: 11 December 2019

If you would like to invest in real estate, you may be interested in a 1031 Exchange. Still, you may know little about this type of transaction.

Here is a bit of information to help you better understand it.

What Is the Benefit of a 1031 Exchange?

The 1031 Exchange is named for the section of the IRS code that defines it. The advantage of the exchange is the tax deferral benefit.

The investor can defer their payment of the capital gain taxes of a property that they sell when another similar property is obtained with the proceeds from the first property's sale. Thus, the investor can avoid tax liability as they focus on new properties.

When Should a 1031 Exchange Be Performed?

A 1031 Exchange can be an advantage if the investor owns a property that has appreciated from the time of its original purchase. The increase in value can also mean a significant increase in tax liability. Thus, deferring the taxes and purchasing another property can realize significant savings. 

Also, in some instances, the sale of a property can be more costly than its worth if the investment has depreciated over time. Avoiding the immediate payment of the capital gain taxes as you sell the real estate can be more profitable.

What Types of Exchanges Are Allowed?

While conducting a 1031 exchange, the investor must abide by certain rules. For instance, a 1031 Exchange can only be performed for business or investment properties. Additionally,  the exchange is not applicable to personal property, such as a primary residence. Also, the replacement property must be equal or greater in value than the original property. 

Still, investors can select from several types of exchanges when selling and purchasing similar properties. They include the following:

  • Simultaneous. This type of exchange takes place when the new property and the property that is being sold both have their closings on the same date.
  • Delayed. During this kind of exchange, the investor sells the first property before obtaining its replacement. A third party maintains the sale's proceeds in a trust for a limited period until the seller obtains another similar property. 
  • Construction. This type of exchange permits investors to use their deferred tax dollars to make improvements to the replacement property while the property's title is held by a designated intermediate party.
  • Forward. A forward exchange allows the investor to purchase the replacement property before selling the initial property. Thus, the investor buys first. 

If you are interested in a 1031 property exchange, consult a real estate professional in your local area.