One of the unique benefits of investing in real estate is the ability to avoid paying taxes at the time of sale through “like-kind” or 1031 exchange. When an investment is sold, the investor is typically required to pay tax on the gain in value. The amount of capital gains tax is based upon the individual's income tax bracket and the length of time the investment was held. For investments held less than one year, the capital gains rate corresponds to the highest marginal tax rate. For investments held longer than one year, gains are taxed at the long-term capital gains rate. A 1031 exchange allows an investor to defer paying the capital gains tax on real estate investments.

Briefly, a “1031 exchange” gets its name from Section 1031 of the IRS code. This provision allows commercial real estate investors to defer capital gains tax from the sale of real estate if the profits are applied to the purchase of another real estate investment within a certain time frame. In other words, you pay no taxes at the time of sale if you apply the proceeds to another real estate investment. The 1031 exchange thus enables the purchase of larger amounts of income-generating real estate, resulting in more rapid wealth creation. Furthermore, the taxes can be deferred indefinitely, and the process can be repeated as many times as desired. This unique tax deferral benefit is not available to investors in paper assets such as stocks and bonds. It is only available to investors in real property. 

There is also a 1031 benefit to your heirs if you decide to defer the taxes indefinitely. If your heirs inherit property from a 1031 exchange, then the property’s basis is “stepped up” to present value. That is, the tax deferment debt is erased, and your heirs can liquidate the investment with no capital gains tax liability. This makes the 1031 exchange advantageous from an estate planning perspective. 

Implementation of the 1031 exchange strategy requires that some specific rules be followed to qualify the transaction under the IRS rules. These include investing in a like-kind investment, transacting within certain time limits, and utilizing a qualified intermediary.
 

Like-kind Investment
 

The subsequent property purchased must be a like-kind investment. This means it must be similar in nature or characteristics. Real estate cannot be exchanged for artwork, for instance. Real property can be exchanged for other real property, such as raw land for a shopping center, or an apartment complex for a bigger apartment complex. In order to maximize the tax advantage of a 1031 exchange, the subsequent property should be of equal or greater value.
 

Time Requirements
 

The second criteria is that there is a certain time frame within which transactions must be completed for them to qualify as a 1031 exchange. Within 45 days after the sale of a property, you must identify the prospective replacement property. Within 180 days after the sale, you must close on the replacement property. If these time guidelines are not adhered to, then the transaction will not qualify for a 1031 exchange and capital gains taxes will be due.
 

Qualified Intermediary

Finally, the transaction must involve a 3rd party, known as a qualified intermediary. The role of the qualified intermediary is to hold the funds from the sale of the first property and then transfer them to the seller of the replacement property. The proceeds from the sale of the first property cannot go to you, the investor. Instead, they are held in escrow by the qualified intermediary and then applied to the purchase of the replacement property (within 180 days). 

Paper Assets vs. Real Estate with 1031
 

The following example demonstrates the potential value of a 1031 exchange. If we assume our investor's income places them in the 15% long-term capital gains tax bracket. Suppose she sells stocks that were held for 5 years and realized a $100,000 gain.  The tax liability in this instance would be $15,000. After taxes, she would have $85,000 available for future investment. 

In contrast, suppose she held a commercial real estate property for 5 years and sold it for a net profit of $100,000. If she utilizes a 1031 exchange when she sells the property, the $15,000 in capital gains tax would be deferred, and she would have all $100,000 available for the next real estate investment purchase. She may eventually decide to liquidate a subsequent investment and pay capital gains, but the 1031 exchange gives her options. She can repeat the exchange and allow further growth of her investment tax-deferred. If this process is repeated over a few transactions, then it can add up to a significant increase in her net worth.

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The information provided here is for general informational and educational purposes only.  It should not be considered a recommendation or personalized investment advice. Please consult a tax professional for applicability to your personal situation.