Few investment tools pack as much punch as a 1031 exchange. By deferring capital gains taxes when selling a property, investors pocket more money to bring to the table for the next project.

What Is a 1031 Exchange?

1031 exchange refers to Section 1031 of the Internal Revenue Code that allows property owners to defer the taxes they would typically owe when profiting from the sale of an investment property. To do this, the funds from the sale of the subject property must go directly to the purchase of a property of a “like-kind,” and personal residences do not qualify.

Fortunately, the replacement property does not have to be identical or even a single property. The IRS acknowledges that most real estate will be like-kind to each other and does not require that the two properties be of the same condition or grade.

1031 Exchanges Give Investors More Money to Leverage

The number one benefit of a successful 1031 exchange is that money that would otherwise go to taxes remains in the pocket of investors. The extra funds then give the investor greater buying power for the next property. 

For example, upon selling a property with $200,000 in gains, an investor would pay $40,000 in taxes at the 20 percent capital gains rate. Imagine instead that the same investor completed a 1031 exchange where that $40,000 applied to the purchase price of a new property. If receiving 80 percent financing for the new property, that extra chunk of money is the difference between a $800,000 and $1 million property. 

Benefits Compound through Chain of Exchanges

An investor can only defer taxes through a 1031 exchange; they are not forgiven. But, the deferral snowballs as like property is exchanged for like property, as there is no limit on the number of exchanges. Ideally, the property owner trades up each time for more valuable property. 

In the same scenario as above, the first tax deferral may only be $40,000. As the new properties increase in value, so too do the deferrals. Consequently, over the course of a lifetime, the gains deferred may be astronomical.

Hold Exchanged Property Until Death for Maximum Benefit

While the taxes on gains are only deferred throughout the property owner’s life, the owner’s heirs stand to see 1031 exchange process to fruition. Upon the taxpayer’s death, the heirs who inherit the property receive it on a stepped-up basis. This means that the gains, from the entire chain of exchanges, disappear upon the taxpayer’s death.

How to Conduct a 1031 Exchange

The only downside of 1031 exchanges is that they can be a bit tricky to execute, which could lead to an unexpected tax bill. While the IRS applies a broad interpretation to the ‘like-kind’ nature of the properties, the window for handling the transactions is quite short. 

First, one must identify potential replacement properties within 45 days of the sale of the previous property and then notify the seller or qualified intermediary. Second, purchase the new property the earlier of either within 180 days of selling the old one or by the time the taxpayer’s tax return is due.

1031 Exchanges Benefit Passive Investors

Limited partners in real estate syndications may still benefit from a 1031 exchange without being the sole owner of the property. If the syndication company engages in a 1031 exchange at the termination of the project, then the taxes due on any gains no longer exist. With one less expense out of the way, there will be more profits to divide among investors.