What is a 1031 tax exchange?

A 1031 tax exchange is a special kind of property swap that allows investors to defer federal capital gains and recaptured depreciation taxes following the sale of property. Deferring taxes means that the seller can use deferred amounts as additional investment capital.

The number “1031” refers to Internal Revenue Code Section 1031, which contains the rules regarding this procedure. If properly preformed, a 1031 tax exchange can result in an investor selling a property and reinvesting the proceeds in a new property while deferring capital gain taxes.

IRC Section 1031 (a)(1) states: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

An example of the process can better illustrate how beneficial this is to sellers.

Let us assume an investor sells a property and has a capital gain of $200,000 of which $70,000 is owed as taxes in the form of depreciation, recapture, federal, and/or state capital gain taxes. At this point, the seller only has a remaining $130,000 left to invest into new properties. In effect the investor lost almost a third of his or her profit.

This loss of profit will prohibit the seller from obtaining a higher-value property. Instead of having a full $200,000 to put down on a new property, the investor is now restricted to only having $130,000 on hand. If the seller used his full amount for a 20 percent down payment, $130,000 would permit the investor to only purchase a $650,000 home. If the investor had a full $200,000, though, he or she could afford an $800,000 purchase.

However, had the seller used a 1031 tax exchange, he or she would be able to use all $200,000 of the sale towards the reinvestment in a much more valuable property.

While 1031 tax exchanges help investors to avoid capital gain taxes which carve into their profits from property sales, sellers still need to pay the deferred taxes when the replacement property gets sold.

Investors interested in a 1031 tax exchange should speak with their tax attorney or a qualified accountant since this is not something to be undertaken by inexperienced sellers. Proper forms must be carefully filed for this to work.

Despite the complexity of this reinvestment plan, the exchange is considered one of the most powerful wealth building tools still available to taxpayers and investors.