The IRS has blessed investors with a very powerful equity preservation tool in the form of the §1031 Tax-Deferred Exchange. This page will be a great starting point to learn the basics of how it works, and why you should consider an exchange as part of your real estate investing strategies.
The Benefits of Exchanging
- Allows you to sell an investment property and re-invest 100% of the net equity into a like-kind replacement property while deferring your capital gains and other taxes!
- ❗If you sell a property and do not perform a 1031 Exchange, you will typically give up 20-35% in taxes including federal capital gains, depreciation recapture, state capital gains (varies by state), and net investment income tax.
- If your existing property has appreciated significantly, you can sell it and leverage the power of a 1031 Exchange to “trade up” to a larger or more profitable property. For example, I recently helped a client from Oakland who sold his rental condo and used the 1031 funds to purchase a 4-plex in Mesa, AZ!
- An investor may exchange several smaller properties into one larger property for ease of management.
- Can be used as a powerful estate planning tool
- There are other non-tax reasons for exchanging such as increasing cash flow, reducing operating expenses, increasing net worth, reducing risk, relocating to new markets, or diversifying your real estate assets.
How does it work?
- A properly structured exchange allows an investor to sell one or more appreciated assets (in our case rental or investment real estate) and defer the payment of taxes by acquiring one or more like-kind replacement properties.
- The info-graphic below breaks down the basic process and timeline for what’s known as a Delayed Exchange, which is the most common form of exchange used in real estate transactions. It is called a Delayed Exchange because the the exchanger sells their Relinquished Property on one date, and then acquires the Replacement Property at a later date.
This sounds too good to be true. Why would the IRS allow us to not pay taxes?
Can I elect to perform a 1031 Exchange after I sell my current investment property?
What are the rules to identify the Replacement Properties?
What if I don’t close on a property by the 180th day of the timeline?
Can I come out of pocket with cash to purchase a more expensive property?
What does the IRS code mean when it says the properties must be “like-kind”?
Do you have to invest all net proceeds from the sale of the Relinquished Property into the Replacement Property?