A 1031 exchange, otherwise known as a tax deferred exchange is a simple strategy
and method for selling one property, that's qualified, and then proceeding with an
acquisition of another property (also qualified) within a specific time frame. The
logistics and process of selling a property and then buying another property are
practically identical to any standardized sale and buying situation, a "1031 exchange"
is unique because the entire transaction is treated as an exchange and not just as
a simple sale. It is this difference between "exchanging" and not simply buying and
selling which, in the end, allows the taxpayer(s) to qualify for a deferred gain
treatment. So to say it in simple terms, sales are taxable with the IRS and 1031
exchanges are not. US CODE: Title 26, §1031. Exchange of Property Held for Productive
Use or Investment
Due to the fact that exchanging, a property, represents an IRS-recognized approach
to the deferral of capital gain taxes, it is very important for you to understand
the components involved and the actual intent underlying such a tax deferred transaction.
It is within the Section 1031 of the Internal Revenue Code that we can find the appropriate
tax code necessary for a successful exchange. We would like to point out that it
is within the Like-Kind Exchange Regulations, issued by the US Department of the
Treasury, that we find the specific interpretation of the IRS and the generally accepted
standards of practice, rules and compliance for completing a successful qualifying
transaction. Within this web site we will be identifying these IRS rules, guidelines
and requirements of a 1031. It is very important to note that the Regulations are
not just simply the law, but a reflection of the interpretation of the (Section 1031)
by the IRS.
Why 1031 Exchange?
Any Real Estate property owner or investor of Real Estate, should consider an exchange
when he/she expects to acquire a replacement "like kind" property subsequent to the
sale of his existing investment property. Anything otherwise would necessitate the
payment of a capital gain tax, which is currently 15%, but may go to 20% in future
years. Also include the federal and state tax rates of your given state when doing
a 1031 exchange. The main reason for a 1031 is that the IRS depreciates capital real
estate investments at a 3% per year rate as long as you hold the investment, until
it is fully depreciated. When you sell the capital asset, the IRS wants to tax you
on the depreciated portion as an income tax, and that would be at the marginal tax
rate. Example, if you hold an investment for 15 years, the IRS depreciates it 45%.
It then wants you to pay the taxes on that 45% depreciation. If combined state and
federal taxes are 35% at the marginal rate, that's about 15% of the cost of the property
(one third of 45%). If your property is fully depreciated, it becomes the whole 35%
marginal tax rate. Another way to make it easy to understand is when purchasing a
replacement property (without the benefit of a 1031 exchange) your buying power is
reduced to the point, that it only represents 70-80% of what it did previously (before
the exchange and payment of taxes). Below is a look at the basic concept, which can
apply to all 1031 exchanges. From the sale of a relinquished real estate property,
we should understand this concept so that we can completely defer the realized capital
gain taxes. The two major rules to follow are:
The total purchase price of the replacement "like kind" property must be equal to,
or greater than the total net sales price of the relinquished, real estate, property.
All the equity received from the sale, of the relinquished real estate property,
must be used to acquire the replacement, "like kind" property.
The extent that either of these rules (above) are violated will determine the tax
liability accrued to the person executing the Exchange. In any case which the replacement
property purchase price is less, there will be a tax responsibility incurred. To
the extent that not all equity is moved from the relinquished to the replacement
property, there will be tax. This is not to say that the (1031) exchange will not
qualify for these reasons. Keep in mind, partial exchanges do in fact, qualify for
a partial tax-deferral treatment. This simply means that the amount, of the difference
(if any), will be taxed as a boot or "non-like-kind" real estate property.