Understanding a 1031 Exchange

The IRS Code reads:

“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.”

What it means:

Section 1031 of the Internal Revenue Code states that upon the sale of a property, the investor can use the funds from the sold property to purchase another similar property and not be liable for any capital gains taxes on proceeds from the initial property.

Requirements:

  1. The properties involved must be held for “productive use in trade, business or investment” and must be like-kind.
  2. You must identify your next property purchase within 45 days.
  3. You have to complete the exchange in 180 days.
  4. To defer 100% of the capital gains tax liability, you must meet two requirements:
    a) You have to reinvest all the cash that was generated from the sale of your relinquished property.
    b) The new property must be equal or greater in value to the property sold. 

Benefits of the 1031 Exchange:

1031 exchanges are certainly great transaction tools, but it is an even better wealth building tool.  Real estate investors that continually 1031 exchange throughout their lifetime will build their cash flow and networth significantly more than an investor who chooses to pay his or her income taxes as they go.

The ability to defer the payment of income taxes allows the real estate investor to reinvest 100% of his or her equity (cash position) in replacement investment property and consequently improve his or her cash flows and net worth.