1031 Exchange Basics

What is a 1031 Exchange?

People ask, “Why should I do a 1031 exchange?” I can answer this question in two words: "Financial Leveraging." By doing a 1031 exchange, the taxes you would have paid to the government are now working to earn you money.

A 1031 exchange allows a taxpayer to postpone their long-term capital gains tax when selling an investment property by exchanging both the basis and the gain into a new investment property. This gives an investor financial leverage. If you have a property used for investment or business and you plan on buying another property used for investment or business, then yes, you need to do a 1031 exchange.

In simple terms, a 1031 exchange moves the gain from the sale of an old investment property into the purchase of a new investment property. By moving the gain into a new property, you defer paying tax on that gain into the future.

For example, suppose Jane Doe sells her rental house for $200,000. She bought it five years ago for $150,000. Now using a 1031 exchange, she buys another investment property for $200,000. By following the IRS’s requirements, she is able to transfer all her gain into her new property instead of paying taxes on the sale.

Since the most recent real estate boom, people have become more aware of 1031 exchanges than ever before. Even with this increased awareness, there are still some prevalent misconceptions about this specific section of the tax code. As a 1031 exchange consultant, I hear these misconceptions everyday. Here are the most frequent three I hear:

The sheer number of investment vehicles available to you these days is absolutely staggering. Stocks, bonds, precious metals, commodities, options, derivatives, real estate, etc., etc., etc. - it can make your head spin! Now, all things being equal, none of these investments are better than any other. If you know what you're doing, you can make money in any of them.

When investment real estate is sold, payment of capital gains tax can be deferred IF the taxpayer does a 1031 exchange. In other words, instead of selling the property for cash, the taxpayer exchanges it for a like-kind property. In a 1031 exchange, “like-kind” means exchanging one investment property for another investment property.

A 1031 exchange is NOT ‘a-sale-and-a-purchase,’ but an exchange of one property for another. There must be a written exchange agreement that shows that ALL the steps, from the transfer of the old property to the receipt of the new, is part of an overall plan. That plan being the 1031 exchange.

The rules for an exchange are not complex, but they are strict...

People who have only heard of 1031 exchanges know this much: it has something to do with real estate. Basically, a 1031 exchange works like this:

One of the reasons real estate investors do a 1031 exchange is to defer the capital gains taxes on the sale of their ‘old’ real estate. Many people think that the capital gains tax on selling their real estate is just 15%. Not so! It’s actually much greater in most cases. Here’s why:

Too many people think that profit, or gain, is simply what you sold your old property for minus what you bought it for. Most of the time that’s not accurate. Gain is actually calculated by taking your net sales price and subtracting your adjusted basis.

But it doesn’t stop there. Not only are you going to be taxed on the appreciation or gain of your real estate, but also on the ‘recapture of depreciation,’ more accurately called ‘Section 1250 Gain.’

1031 is a section of the tax code that allows you to sell your investment property (almost any property other than your personal residence), buy a new investment property and defer all of the capital gains taxes from the old property to the new one.

This does three things for you:

1. you don't have to turn over to the government upwards of a third of everything you made on the property

2. you now have all that extra money to spend on the new (replacement) property

3. it may help you avoid the dreaded Alternative Minimum Tax (AMT). In short, its way of preserving your working capital as you build your real estate empire.

all the money you would have paid to the government is now available to buy a better condo...

If you own business or investment property, you may be able to save thousands of dollars by exchanging your assets instead of selling them.

A like-kind exchange under Internal Revenue Code Section 1031 allows you to defer the taxes on capital gains by exchanging rather than selling. This tax deferral is available for both real estate (dirt and everything screwed into it) and personal property (things you can pick up and move). This can save you in Federal and State taxes anywhere from 15% to 35% on each dollar of gain realized, depending on your state’s tax rates.

There are a few basic steps that will be required under code section 1031 to enjoy this great financial advantage.

At the offices of the 1031 Exchange Experts, it astonishes us each time we hear a potential client choose to go with another company because of cheaper fees. Arizona’s KTAR.com just broke a story of a 1031 exchange husband and wife team that, if convicted, could face a combined 82 years in prison.

The couple in question, Gordon Deibler and Renata M. Majda-Deibler, have been indicted on a combined 26 counts of fraud and forgery. Ms. Majda-Deibler is also being sued for ‘breach of lease’ in an Arizona civil lawsuit, according to azcentral.com (case number CV07-53037).

...The clients who lost everything may have saved a couple hundred dollars...