Understanding the Advantages of a 1031 Exchange

Real estate investors who want to defer capital gains have a neat option: they can take advantage of Internal Revenue Code Section 1031 to exchange out of one investment or business property for a “like-kind” property or equal or greater value. Usually, no gain or loss is recognized when you do a 1031 exchange.

The one big demerit of a 1031 exchange is that you don’t have quick access to the sale proceeds – they go into an escrow fund maintained by a qualified intermediary. That has to happen, for if you take control of the proceeds, you have a sale, not a like-kind exchange.

The advantages, however, are numerous. The definition of “like-kind” property is quite broad – the IRS website states that properties are like-kind so long as they “are of the same nature or character, even if they differ in grade or quality.” Additionally, it states that “real properties generally are of like-kind, regardless of whether the properties are improved or unimproved.” So an apartment complex might be exchanged for acreage, a strip shopping center for a horse ranch. A vacation home qualifies for a 1031 exchange if you live there less than 14 days a year or less than 10% of the time it is rented, or if you use it in some kind of trade or business venture.

In addition, you get 180 days to close on a new property upon the sale of the old one, including a 45-day window to identify a “like-kind” property.

Just how much money might you save in a like-kind exchange? Here’s a simple, hypothetical example. A real estate investor buys a duplex for $200,000. Five years later, she decides to get out of that property and replace it, but she doesn’t want to rack up capital gains taxes and taxes on depreciation. So she puts the duplex on the market for $300,000, gets that price, and hunts for a replacement property using a like-kind exchange.

If this were a typical real property sale, she would be looking at $100,000 in capital gains on the duplex and $36,365 in depreciation claimed (using the IRS formula in Publication 527, whereby  residential investment properties can be depreciated over a 27.5 year time period, i.e., $7,273 x 5 = $36,365). Her ensuing tax liability would come to $136,365.

Rather than be burdened with that kind of tax liability, our investor goes the 1031 route. She identifies a replacement property within 45 days, and closes escrow within 180 days. By accomplishing this, she successfully defers taxes on the entire $136,365 and she is able to direct those proceeds toward buying the replacement property.

A 1031 exchange using a qualified intermediary can result in significant tax deferral and represent a convenient step for the savvy real property investor.