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November 24, 2019

1031 Exchanges Explained

If you own a real estate investment property and would like to sell it in exchange for another one, the 1031 exchange might work for you. Learn more about what a 1031 exchange is and the benefits to you, such as the capital gains tax deferral.

What is a 1031 Exchange?

A 1031 exchange is defined under the U.S. Internal Revenue Code Section 1031. Under this provision, you can sell an investment property and put the money into a like-kind investment property of the same or higher value. 

The Tax Benefits of a 1031 Exchange

By processing the sale of your investment property as a 1031 exchange rather than a regular sale, you can defer the capital gains taxes until you sell the replacement property. You still pay the capital gains tax when you sell the new property. However, it gives you time to prepare for that eventuality. Most 1031 investors hold the new property around 7 or 8 years.

Qualified Intermediaries

Under 1031 exchange real estate investing, the property sale remains taxable. However, a qualified intermediary can hold the funds and send them to the replacement property owner. A “qualified intermediary” is an entity — company or person — that holds the funds until they are sent to the replacement property seller. Under the IRS rules, a qualified intermediary can’t have a formal relationship with either of the parties involved in the exchange.

When is a 1031 Exchange a Good Idea?

A 1031 exchange makes sense in real estate investing under the following circumstances:

  • You might want a property with a greater potential return on investment or one that diversifies your existing assets.
  • You might want to exchange a property you manage for a property managed by someone else.
  • For estate planning, some real estate investors use it to consolidate their holdings into a single property.
  • A 1031 exchange saves you money on depreciation

How the Tax Deferral Works

When you carry out a 1031 exchange, the main benefit is the ability to put off paying taxes. In the short term, this frees up capital so you can buy a better replacement property.

If you are considering a 1031 exchange, remember that this transaction typically involves a high minimum investment and an extended holding time. Due to these constraints, these transactions suit investors with a high net worth. The complex 1031 exchange requires professional management.

Depreciation and Your 1031 Exchange

Here’s how it works. Depreciation is a fraction of the cost you can write off on your annual taxes. It represents the wear on the property. If you sell the property, depreciation impacts the capital gains tax. Capital gains are based on the net-adjusted basis of the property, or the original purchase price added to any capital improvements made minus depreciation.

So, when you sell an investment property at a cost higher than the depreciated value, you may need to recapture the depreciation. The depreciation must be added to your taxable income when you sell the property. This is often a sizable amount. Depreciation recapture increases each year you hold the property, so a 1031 exchange is especially helpful for investors who want to avoid a massive addition to their annual taxes.

1031 Exchange with DiversyFund

DiversyFund can help you with your 1031 exchange. Contact us today regarding our multifamily properties for investors seeking high returns.

You can invest passively and defer paying capital gains when you 1031 exchange a real estate investment property. Whatever reason you have for preferring a 1031 exchange over a tradition sale and new property purchase, we can guide you through the decision-making process.