What is a 1031 Exchange?

An IRC §1031 exchange allows someone to sell a property and then reinvest the proceeds of that sale in another property, but to defer payment of any capital gains taxes until a later date.

The deferral of taxes began many years ago. There were times where farmers or ranchers would simply exchange parcels of land with each other with no money changing hands. Since there was no cash in the transaction, there were no funds to pay the taxes. In order rectify what was considered to be an injustice to the parties, IRC §1031 was added to the tax code in 1921. 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.”
A 1031 exchange offers considerable benefits to investors and business owners. Consider the following example:

• An investor has a capital gain of $600,000 capital gain and would incur a tax liability of approximately $200,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. This leaves only $400,000 in net equity remains to reinvest in another property.

• Assuming a 25% down payment and a 75% loan-to-value ratio, the investor would only be able to purchase a $1,600,000 replacement property.

• Using a §1031 exchange, the same investor would be able to reinvest the entire gross equity of $600,000 in the purchase of $2,400,000 replacement property, assuming the same down payment and loan-to-value ratios.

This example demonstrates that 1031 exchanges allow investors to defer capital gain taxes as well as facilitate significant growth in their real estate portfolio and increased return on investment. This is such a wonderful tool for investors, that the Regulations and Rules regarding a 1031 exchange are definite and strictly enforced. It is essential to have a comprehensive knowledge of the exchange process and the Section 1031 code.

These exchanges are often called “Starker” exchanges, named after the T.J. Starker case against the Internal Revenue Service. Because of that case, numerous rules were drafted that must be followed. Failure to follow those rules will cause the exchange to fail, and the investor will be liable for all capital gains taxes. American 1031 Exchange can help you to is your resource to obtain accurate and thorough information about the entire 1031 exchange process.