1031 Exchanges - Good for Investors, Good for the Country

A 1031 exchange is a tactic used by real estate investors to indefinitely defer tax liability on a property's sale. This is achieved by giving the rights to a property one would like to sell to an intermediary, who holds on to the funds gained from the sale of the relinquished property and uses them to buy a replacement property that complies with the rules set out in Section 1031 .

While the present popularity of the 1031 could lead you to believe that it only recently came on the scene, this is untrue. Actually, the history of the 1031 extends all the way back to 1921, although at its conception, it was quite a bit different than what we today think of as an exchange. Section 1031 really came into its own in the 1970s, which saw a host of significant modifications in the manner that exchanges were regulated. These modifications paved the way to a farther-reaching conception of the process and also generated greater interest among property investors.

The indefinite capital gains deferral an exchange grants to the taxpayer may, at first, seem to be a sort of gift from the US government, however it is, in reality, closer to an interest-free loan, because there is an expectation that the investor will “repay” the extra funds gained from the deferral by paying capital gains taxes upon the eventual sale of a replacement property. In addition, this interest free loan may be kept indefinitely; an investor can choose to conduct any number of exchanges before ultimately deciding to sell outright, at which point capital gains taxes must be paid.

The 1031 exists as a mutually advantageous agreement between investors and the U.S. government, providing a benefit for the U.S. economy as well as the individual taxpayer. By viewing the transfer of value in an exchange as representing a continuation of a preexisting investment rather than as a separate transaction liable for taxation, taxpayers are given the opportunity to move their funds to the most profitable possible investments, which, in turn, boosts the economy by bolstering job growth.

Like anything else, the 1031 exchange has its detractors. Some advocates of change in Section 1031 will argue that the tax free profit gained by to the taxpayer in a 1031 lends them an unreasonable advantage. Another frequent concern is that the strict time limits attached to some aspects of the exchange procedure may engender a frantic rate of buying, resulting in an increase in the cost of replacement properties. These complaints, however, are only loosely based in reality, and the odds that the 1031 exchange procedure will see noteworthy changes in the near future are quite slim. In general, most will agree that Section 1031 is greatly helpful to all parties involved, allowing taxpayers increased profits on the sale of property while also encouraging job growth and consequently promoting the greater good of the country as a whole. There is little doubt that the 1031 will be a mainstay of the property investment business for years to come.