Understanding 1031 Tax-Deferred Exchanges

Real Estate

Understanding 1031 Tax-Deferred Exchanges

If you own a rental or other investment properties, you should know about the 1031 tax-deferred exchange. The 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code (IRC), which allows for tax deferrals on the sale of a property used in a trade or business or held for investment when exchanged for like-kind replacement property.

A properly structured 1031 exchange will allow you to re-invest the proceeds from selling your investment property(s) into another like-kind property and defer capital gains taxes, as long as you meet certain criteria. 

Role of the Qualified Intermediary (QI)

A Qualified Intermediary is a person or company that facilitates the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the (new) replacement property. Under section 1031, any proceeds received from the sale of a property must remain taxable and a QI ensures that the 1031 exchanges are fully executed in accordance with IRC rules.  

Benefits of 1031 Exchanges

If properly executed, a 1031 exchange could help you reap the following benefits: 

(1) Equity Preservation - defer your capital gains taxes
(2) Leverage - use equity from current investment to buy a higher value property
(3) Diversification - geographically or by asset class
(4) Depreciation - manage high depreciation costs due to long-term ownership
(5) Retirement/Estate Planning - buying real estate for your heirs or buying real estate in your desired retirement location

Limitations of 1031 Exchanges

A 1031 exchange comes with a specific set of IRC rules. All the rules must be strictly adhered to, in order for a 1031 tax exchange to by fully executed. Time restrictions are mandatory and it is important to recognize that your capital gains taxes are DEFERRED temporarily; it is not tax-free. Potential replacement properties must be identified and acquired within specific time periods, the property to be sold and the acquired property must both have been held for investment/business purposes, and risks depending on ownership type. 

There are many details involved in executing a 1031 exchange. If you are interested in learning more about 1031 tax-deferred exchanges or investing in rental properties, call me at 425.246.3671 or email yeeyontan@cbbain.com!