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1031 Exchange: The Basics

A tool for real estate investors, explaining 1031 Exchange Tax Deferral

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So often when dealing with investment property, brokers are asked about a 1031 Exchange. I work with many clients who own investment property and take advantage of the 1031 Exchange Tax Deferral. Many people are not familiar with this option or are confused by the process. Under Section 1031 of the United States Internal Revenue Code (26 U.S.C. ยง 1031), a taxpayer may defer recognition of capital gains and related federal income tax liability on the exchange of certain types of property. These tax-deferred exchanges are only available for investment property and do not apply to the sale of primary residences or second homes.

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This type of deferral allows for funds that would otherwise have to be used to pay the capital gains tax on the equity gain from the sale of the property, to be allocated toward an equal or greater investment. Essentially, it allows for a seller to avoid the capital gains tax on the equity gain, if the seller reinvests the realized gain back into the real estate market.

Often times the caveat of "like for like" is confused. Purchase of property through 1031 exchange does not mean that a seller is limited to duplex for duplex, as an example. Investors can take advantage of this, so long as the property purchased is for investment purposes only and the purchase is of equal or larger re-investment back into the real estate market. Therefore, an example of this could be a seller who sells a four-plex and buys a single-family rental home(s), or perhaps a commercial building. A seller can also purchase bare land, as the property is not required to be income-producing under the guidelines of the tax code. In addition, a seller is not limited to purchasing in the same area should they want to reinvest the gains in another market or state.

The most common type of exchange is a "delayed or straightforward exchange." With this type of exchange a seller has 45 calendar days from the date of close of the relinquished property to identify a replacement property. Once a seller has identified the property, has an accepted offer and notified the exchange accommodator in writing of the property identification, the seller then has 180 calendar days to close escrow on said property. One thing to keep in mind with 1031 exchanges: a seller must use a certified third-party exchange accommodator, and it's wise to consult with a tax advisor and financial planner prior to executing an exchange.

A 1031 Exchange is a fantastic tool for real estate investors and there are many other types of 1031 exchanges. If you would like further information on exchanges, consider looking at exchangeresources.net.

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