Real estate investors too often fail to understand the power of the 1031 exchange. Normally an investor is taxed on any gain realized from the sale of an investment or rental property. However, through a section 1031 exchange, the owner is able to defer capital gains tax until some date in the future.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized for tax purposes on the exchange of property held for productive use in a trade or business or for investment purposes. The1031 exchange allows a property owner to trade one or more relinquished properties for one or more replacement properties of “like-kind” and defer the federal income taxes and often the state income taxes on the transaction.
The theory itself is not too complex. Since the real estate investor is allowed to reinvest the sales proceeds into another property, any economic gain has not been realized and, accordingly, no funds have been generated to pay any tax. In other words, the taxpayer’s investment has not changed, only the form has changed. For example, an apartment building has been exchanged for raw land. It would be unfair to require the taxpayer to pay tax on any “paper” gains.
But realize that the like-kind exchange under Section 1031 is able to defer capital gains tax, but it is not a tax-free transaction. At some point in the future when the replacement property is ultimately sold (and not as part of another exchange), the original gain that was deferred, plus any additional gain that was realized since the purchase of the replacement property, is subject to tax.
The benefits of utilizing a 1031 exchange are clear. It is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of like-kind properties. By being able to defer the capital gains tax, there is more capital available to invest in other properties. Ultimately, it’s like receiving an interest free loan from the government in the amount you would have paid in income taxes. In addition, any gain from depreciation recapture is postponed. The ability to buy and sell properties to reposition your investment portfolio without paying tax on any gain is critical. Make sure you consider a 1031 exchange for your next real estate transaction.