1031 Exchange - How You Can Indefinitely Defer Income Taxes

1031 Exchanges are excellent tools to reduce income taxes. Known both as "tax free exchanges" and "1031 exchanges" (based upon the enabling section of the federal income tax code) this tool allows investors to sell real estate without paying income taxes (at the time of sale). Real estate owners or investors expecting to acquire property subsequent to the sale of existing property can indefinitely defer income taxes by utilizing a 1031 exchange. 1031 exchanges have been available for over 20 year. Their popularity seems to have increased sharply over the last 7-10 years as their benefits have become known. In a typical property sale, an owner has to pay taxes on any gain. In some cases, a 1031 exchange does not make sense or is not practical. If an investor is trying to reduce his real estate asset allocation, or if a limited partnership has 20 investors with diverse interests, a 1031 exchange would not make sense. In a properly executed Section 1031 exchange, the realized tax is deferred. These transactions are sanctioned under Section 1031 of the Internal Revenue Code and are often referred to as "1031 exchanges," "like-kind exchanges" or "tax-deferred exchanges." What is a 1031 Exchange?A 1031 exchange provides the investor the opportunity to defer 100 percent of realized capital gains. This equates to an interest-free, no-term loan on taxes due until the property is cashed-out. Most often, the capital gain taxes are deferred indefinitely because investors continue to exchange from one property to the next, and increasing the value of their real estate investments with each exchange. By not utilizing a 1031 exchange, property owners or investors would necessitate the payment of capital gain taxes in amounts, which can exceed 20 percent to 30 percent, depending on the appropriate combined federal and state tax rates. In other words, when purchasing replacement property without the benefit of a 1031 exchange in business real estate, your buying power is dramatically reduced and represents only 70 percent to 80 percent of what it did previously. What Qualifies for a 1031 Exchange?Properties that qualify for a 1031 exchange include any real estate used for business, trade or investment. Examples of 1031 exchange properties include apartments, office buildings, multiplexes, single-family or condo rentals, raw land, farms, ranches, and commercial and industrial properties. Also, you are not limited to exchanging for property similar or exactly like your existing property. Examples of qualified 1031 like-kind properties and like-kind exchanges:

1. apartment building for farm/ranch
   
2. office building for hotel
   
3. raw land for retail space
   
4. unimproved property for commercial property
   
5. airplane for airplane

1. The real property you sell and the real property you buy must both be held for productive use in a trade or business or for investment purposes and must be like-kind.
   
2. The proceeds from the sale must go through the hands of a qualified intermediary and not through your hands or the hands of one of your agents or else all the proceeds will become taxable.
   
3. All the cash proceeds from the original sale must be reinvested in the replacement property; any cash proceeds you retain will be taxable.
   
4. The replacement property must be subject to an equal level or greater level of debt than the relinquished property or the buyer will either have to pay taxes on the amount of the decrease or have to put in additional cash funds to offset the lower level of debt in the replacement property.