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What is a 1031 Exchange

(And How it Works)?

Sometimes called a like-kind exchange, a 1031 Exchange gets its name from the 1031 IRS code section. It's a tactic that investors can use to help reduce taxes and reap some other benefits. In short, property investors will sell one property and use the proceeds to purchase a similar property to replace it. When the investor purchases another "like-kind" property, they can defer taxes on the capital gains of the property that was sold.

What is a like-kind property that might be eligible for a 1031 Exchange? This term is fairly broad. Basically, the two properties involved in the exchange have to have the same nature, though they can be very different in quality or grade. In other words, the taxpayer can't exchange machinery for rental property. However, they're usually allowed to exchange almost any sort of real estate, just so long as it's not their own personal property. So, an investor can't sell his or her own home to buy a rental house. However, the investor can sell a rental house to purchase another one or even an apartment or office building

How can property owners benefit from this exchange strategy? For instance, a property investor might own some high-maintenance property that requires lots of upkeep but doesn't generate adequate cash flow. The only rule to take advantage of deferring the entire amount is that the purchased property value has to be equal or to exceed the sold property. In this case, the investor can take advantage of buying a better investment property and having the ability to defer capital gains taxes.

One example of a 1031 exchange was of a woman who owned some older properties in California. These rental homes were in a neighborhood that was no longer desirable, but since they were in California, the value was still relatively high. She exchanged these rentals for properties with a similar value in Texas.

Just because Texas property values tend to be much lower, she got newer properties that generated more consistent revenue and required less upkeep. She also got to take advantage of a 1031 Exchange to defer any taxes on her capital gains, so she had the full amount of the sale to invest in the better properties.

There are three basic IRS rules that the property owner will have to follow to complete this exchange. First, the exchange must be completed in 180 days, or about six months. By the 45th day after the sale, the investor has to identify three likely properties, and the final property they buy must be very similar to those. Finally, the purchased property has to be of equal or greater value to the sold property.

Note that a 1031 Exchange is only good for investment or commercial properties. It can't be used on personal properties. Because of other areas of the tax code, most people who sell their personal homes aren't so worried about capital gains anyway.

On the other hand, the exchange does not have to be one-to-one. In other words, the taxpayer could sell one property in exchange for multiple others. Likewise, the taxpayer could sell multiple properties in exchange for just one. The amount of properties doesn't matter. It only matters that the new purchases are valued at least the value of the one that was sold.

In summary, a 1031 Exchange gives property investors a chance to defer capital gains on the sale of properties. This can give investors a chance to trade up to better opportunities and defer capital gains on their taxes. In some cases, investors can still do partial exchanges if the new property isn't valued as high as the sold one