What is a 1031 Exchange?
Thanks to IRC 1031, a properly structured exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC 1031 (a)(1) states: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” To understand the powerful protection an exchange offers, consider the following example: • An investor has a $200,000 capital gain and incurs a tax liability of approximately $70,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold. Only $130,000 remains to reinvest in another property. • Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property. • If the same investor chose to exchange, howeve
A “1031 exchange” refers to a method of deferring tax on the sale of an interest in real property allowed under section 1031 of the Internal Revenue Code. In brief, it allows a seller to defer tax on a gain that would otherwise be realized on a sale of property if the proceeds from the sale were reinvested in like-kind property. It’s quite common for a 1031 exchange to be involved in some manner in a commercial real estate transaction. A seller must contractually arrange to convey his or her interest in the property being sold in exchange for receiving an interest in another piece of commercial property. If cash is involved, an escrow company or facilitator usually it, because treatment under section 1031 won’t be possible if the proceeds are paid to the seller even for an instant. In practice, however, the rules for a 1031 exchange can be quite complex and it is easy for a seller to run afoul with them. It’s always advisable to have competent legal counsel involved in the transaction.
