1031 exchanges provide investors with one of the best tax strategies for preserving the value of an investment portfolio.
By using an exchange the investor is able to deter capital gain taxes that would otherwise be incurred on the sale of the investment property.
1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all 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 is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
When a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. The taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. The investor can then use the entire amount of the equity to purchase a substantially more replacement property.
To qualify as an exchange the relinquished and replacement properties must be qualified “like-kind” properties and the transaction must be structured as an exchange. A company that specializes in 1031 exchanges can be the “Qualified Intermediary” will provide the investor with the necessary reciprocal transfer of properties to create the exchange and protect against actual and constructive receipt of the exchange funds as required under IRC code 1031.
Whether the investor’s property is owned free and clear or encumbered, the benefits of a tax deferred exchange are significant. The tax dollars saved by an exchange can be utilized to purchase additional investment property.
Take a look at the example below.