1031 Tax Deferred Exchanges

I was reading about some changes in the law for last year relating to 1031 exchanges and thought this might be a good opportunity to discuss what a 1031 exchange was, what  the benefits are, and what the perils of an exchange might be.

Section 1031 of the IRS code allows for an owner of real property to sell investment property and reinvest the proceeds into another real estate investment without having to pay the capital gains taxes until the new property is sold.  If an owner continues to use multiple 1031 exchanges throughout their life, they may never pay the capital gains taxes and their heirs could inherit the property with a new basis, based on the value at the time of inheritance.  The more time that passes, the more significant the savings can be, and the growth is exponential.

To illustrate this, if an owner has a capital gain of $100,000 on a property, she may have a tax liability of $35,000 (recapture tax, state and federal capital gains taxes) leaving her $65,000 to reinvest.  If she invests this in a new building and uses this as a 20% down payment, she could buy a building worth $325,000.  If she did a 1031 exchange she could use the whole $100,000 as a down payment and buy a building worth $500,000 in the same scenario.  As the value of the building increases and the loan payoff decreases, there will be significantly higher proceeds to reinvest over time by using the tax deferred exchange.

There are many rules that must be followed in order to do the exchange properly.  It is best to seek the advice of a professional and have everything set up appropriately, before the first property is sold.  The owner cannot control the funds from the sale of the first property, but they must be held by an intermediary.  The intermediary then uses the funds to buy the second property.  The owner has 45 days from the sale to identify the property or properties they intend to buy and 180 days to close on them.

It is important to have a reputable, well capitalized and insured intermediary.  The new law for 2010 deals with the fact that some of the intermediaries that were holding funds went bankrupt and the owners lost their money.  The new purchase couldn’t be completed in the 180 day time frame and the IRS used to require the taxes due to be paid, even if the money was not there!  It would never be good to lose your money, but at least now, the new law does not require the owner to pay taxes until the year the funds are recovered.

Please feel free to forward any questions to me or contact me for more information on using a 1031 tax deferred plan in your real estate investment strategy.

-Dan Stiebel, CCIM

Dan Stiebel

Dan Stiebel

Associate Broker
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