Articles

In simple terms, a 1031 exchange moves the gain from the sale of an old investment property into the purchase of a new investment property. By moving the gain into a new property, you defer paying tax on that gain into the future.

For example, suppose Jane Doe sells her rental house for $200,000. She bought it five years ago for $150,000. Now using a 1031 exchange, she buys another investment property for $200,000. By following the IRS’s requirements, she is able to transfer all her gain into her new property instead of paying taxes on the sale.

Since the most recent real estate boom, people have become more aware of 1031 exchanges than ever before. Even with this increased awareness, there are still some prevalent misconceptions about this specific section of the tax code. As a 1031 exchange consultant, I hear these misconceptions everyday. Here are the most frequent three I hear:

You and your co-partners, Fred and Sue, have decided to sell the small apartment building that you boght a few years ago. You got it for a steal and you've got a nice profit in it. It's not been on the maket long and you now have a full price offer.
You've always assumed that when you sold this property the three of you would roll into the purchase of another property, but Fred just told you that he wants to take his share and buy a new pickup. Yikes – and now Sue isn’t she so sure that she wants to buy another property. You don’t want to cash out because you’re pretty sure that Uncle Sam will take all your gain in taxes. Maybe selling the building wasn’t such a great idea.

A 1031 exchange is a technique that investors commonly use to transfer property tax-free. However, our sophisticated investors are using 1031 exchanges to transfer large amounts of wealth, tax-free to their children.

This is how it works:

Mom and Dad own a building that is worth $100,000 and is free and clear. Finding a new building worth $150,000 the sell their old building and use a 1031 exchange to buy an undivided two-thirds interest in the new building for cash. Their children buy the other undivided one-third interest.

A year or two later they sell the building for $250,000 of which $166,667 is the parents’ two-thirds share with the balance of $83,333 belonging to the children. Both the parents and the children do 1031 exchanges and buy a new property for $400,000 of which $166,667 (or 42 percent) is the parents, and the balance of $233,333 (or 58 percent) belongs to the children.

Section 1031 is an IRS code that allows you to defer real estate capital gains taxes (in some cases, a lot of capital gains taxes). The rules aren't impossible to follow, but they aren't easy, either.

One of the rules that causes a lot of angst, especially in a fast-moving real estate market like we have now, is the requirement that you have forty-five days to make a list of replacement properties you might want to buy. Anything you purchase to complete your exchange must be on that property identification list. You create your identification list on a form provided by your Qualified Intermediary (the 1031 specialist the law requires to guide you through the process).