What is a 1031 Exchange?

What is the 1031 Exchange?

If you are an investor, you are probably familiar with the term 1031. In simple terms, IRS section 1031 is a like-kind exchange or an exchange of one property for another. However, there are many tax implications and time frames involved that can make the concept a bit hard to grasp.

Read on to find out more about 1031’s, what they are and how you can use them to your advantage.

What is a 1031?

A 1031 is a property swap, but unlike most exchanges, there will be limited or no tax due during the exchange. This is because the swap will be recognized as a transaction with no capital gain. This allows your investment to grow with no tax being owed.

For example, if you bought a property for $100,000 five years ago and it now worth $250,000, if you sold it you would need to pay capital gains tax on $150,000. A 1031 exchange allows you to defer paying tax if you reinvest the $250,000 in a different property.

You can do a 1031 swap an unlimited amount of times and you can continue rolling over your profits into new investments. Although you continue to profit, you will not have to pay taxes until you decide to cash out.

At that point, it is hopeful that you will only have to pay one tax, usually 15-20%. Some lower income investors may not be taxed at all.

This is designed for investments and business properties.

The main benefit of a 1031 exchange is that, unlike buying and selling a property, the tax deferral makes it easier for you to reinvest your money.

As an investor, here are some reasons why you might want to utilize a 1031 exchange:

·        To acquire a managed property as opposed to one you will have to manage yourself.

·        To diversity assets

·        To find a property that offers a better return potential

·        To consolidate several properties into one

·        To divide a single property into several assets

·        To reset the depreciation clock

Why is Depreciation Important?

Depreciation is the cost of a property written off each year due to wear and tear. When a property is sold, the price is based on its net adjusted worth which is the original purchase price plus improvements minus depreciation.

If a property sells for more than its depreciated value, the seller may be taxed for depreciation. In this sense the depreciation will be recaptured.

Depreciation recapture increases over time but a 1031 allows you to avoid the taxes on the recapture. However, it will factor into the exchange rate of your 1031.

Qualifications for 1031 Exchange

When utilizing a 1031 exchange, you can exchange any type of property for any other. For instance, you can exchange a commercial property for a lot, or a residential property.

However, the property being exchanged must be held for investment, not resale or personal use. This usually means the property has been owned for at least two years.

To fully take advantage of all a 1031 has to offer, replacement properties should be of equal or greater value than the original property. Replacement properties must be identified within 45 days and the exchange must be completed within 180 days.

Now that you understand some basics of the 1031 exchange, what do you think? Will you be making these transactions to boost your potential income?

The above is meant as a general guide, for specific tax questions please speak to a professional accountant.