1031 exchange: What is it and how best to use it in a transaction?

Aalto Insights Team
Jan 17, 2023

What is a 1031 Exchange?

Real estate investing can be a great way to build wealth, but it also comes with certain tax implications for buyers and sellers. One strategy that savvy investors and taxpayers use to mitigate these taxes is a 1031 exchange, also known as a like-kind exchange or Starker exchange. This article will cover how this sort of exchange works in real estate.

A 1031 exchange is a tax strategy that allows investors to defer paying capital gains taxes and avoid depreciation recapture on the sale of an investment property. The IRS internal revenue code (irc) allows investors to defer these taxes (aka tax-deferred payments or deferral) as long as the taxable sale proceeds are reinvested into a similar property, known as the "replacement property" after the close of escrow.

To facilitate this exchange transaction, an exchange accommodation titleholder (EAT) or exchange facilitator, also known as a Qualified Intermediary, is often used to hold the proceeds from the sale of the original property and disburse them to the purchase of the new property.

The rules of a 1031 exchange are strict, and if not followed correctly, the investor would have to pay depreciation recapture and capital gain taxes on the transaction. A build-to-suit exchange is a variation of 1031 exchange, where the investor purchases a property and simultaneously starts to construct or improve a new property that is tailored to their needs with the proceeds of sale, under a specific set of guidelines.

Properties must be considered like-kind in order to qualify for 1031 exchange

To qualify for a 1031 exchange, the properties involved must be held for investment or for use in a trade or business and must be considered real property. Additionally, the properties must be considered "like-kind," which means they are of the same nature, character, or class. The examples of like-kind properties include rental property, vacation home, raw land, and commercial property.

A primary residence does not qualify as a like-kind property as it is not held for investment or trade or business purposes. However, you are allowed to purchase a property of greater value or to contribute additional funds to acquire a property that is more than the value of your exchange funds. There are capital gains taxes associated with this sort of scenario where the market value of the replacement property is higher than the original, so be sure to speak with a professional about potential tax liability.

Rules and depreciation for 1031 exchanges

It's important to note that there are specific timeframe and other requirements to complete a 1031 exchange and it is best to consult a tax professional and use a Qualified Intermediary to ensure that the transaction is completed in compliance with the IRS regulations and exchange rules. It is also important to consider property depreciation and ensure that this property exchange is not involving a personal property that is used as a primary residence.

Depreciation is a method used to spread the cost of a property over its useful life for tax purposes.

The way depreciation works is that it allows property owners to take a tax deduction each year for a portion of the cost of the property, which reduces their taxable income. When a property is sold, any remaining depreciable basis (the original cost of the property minus the sum of all depreciation taken to date) must be "recaptured" as ordinary income and taxed at the higher ordinary income tax rates, rather than the lower capital gains rates.

However, when a property is sold through a 1031 exchange, the depreciation that has been taken on the property being sold does not have to be recaptured because the proceeds are being used to purchase another property. This allows the investor to defer paying taxes on the depreciation that was taken on the property being sold, and to continue taking depreciation on the new property.

Examples of 1031 exchanges in real estate

Example 1: John, a real estate investor, owns a multi-family rental property in an LLC in Los Angeles that he wants to sell. Instead of paying taxes on the sale, which will affect his cash flow, John decides to complete a 1031 exchange and use the proceeds to purchase a larger rental property in San Diego which could be a potential replacement property for this property exchange. By following this exchange process, John can defer paying taxes on the sale of his Los Angeles property until he decides to sell the San Diego property. Essentially, this type of exchange will be tax-free as John, the property owner, will not need to recognize this transaction as a taxable gain or pay a form of income tax on the relinquished property.

Example 2: Sarah, a business owner, owns a commercial building that she uses for her business, not for personal use. She wants to sell the building and use the proceeds to purchase a new commercial building to expand her business. By completing a 1031 exchange, Sarah can defer paying taxes on the sale of the first commercial building until she decides to sell the new property. This allows her to expand her business without being held back by a large capital gains tax bill and this will not show up on her tax return.

A 1031 exchange allows investors to defer paying capital gains tax

A 1031 exchange is a powerful tax code strategy that allows real estate investors to defer paying taxes on the sale of an investment property. 

This is a crucial part of estate planning for many business owners. By reinvesting the proceeds from the sale into a similar property, investors can grow their real estate portfolios, expand their businesses through exchange properties, and maximize their return on investment all without incurring a large capital gains tax bill. 

If you are thinking about a 1031 exchange, be sure to consult with a tax professional and use a Qualified Intermediary to ensure that the transaction is completed in compliance with IRS regulations.

If you have any specific questions or terms you'd like us to define, please share them with us at hello@aalto.com. We’d love to hear from you, and we’re here to help. Get started on your home journey at aalto.com.

Aalto is a real estate broker licensed by the State of California, License #02062727 and abides by Equal Housing Opportunity laws. This article has been prepared solely for information purposes only. The information herein is based on information generally available to the public and/or from sources believed to be reliable. No representation or warranty can be given with respect to the accuracy of the information. Aalto disclaims any and all liability relating to this article.

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