1031 exchange gets its name from the Statute. I.R.C. §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.”
The code sounds complex, and it has been cited as the most powerful wealth building tool still available to taxpayers. But you should not be intimidated or mystified. In essence, this provision allows taxpayer to sell income-producing, investment, or business property and replace it with like-kind property without paying federal income taxes on the transaction. This includes assets as diverse as patents, copyrights, trucks, barges, paintings, coins, and of course, real estate.
An example will illustrate the advantage.
Lei owns a small apartment building with 4 units (she lives elsewhere). She paid all mortgage. Lei purchased the property for $200,000, and because of depreciation taken for the past years, her adjusted tax basis is $100,000. The building’s market value is $400,000. Lei decides to sell this building and purchase another building, which also sells for $400,000.
- Option 1. Lei could sell her building on the open market. She will get $400,000. Since her tax basis is $100,000, she will realize $300,000 in capital gain. Since she has held the building for more than 1 year, she will be taxed at 15% for the $200,000 of pure gain ($200,000 * 15% = $30,000). Moreover, Lei will recapture $100,000 of depreciation taken at 25% ($100,000 * 25% = $25,000). As the result of this transaction, Lei will have to pay $55,000 in federal taxes. Without other money, Lei will not be able to buy the building that sells for $400k because she has only $345,000 in her pocket ($400,000 – $30,000 – $25,000 = $345,000).
- 1031 Option. Lei can sell her current property and purchase another property without paying any tax. She has saved $55,000 in taxes.
As you can see, 1031 exchange is great when you trade equal or up on value. It is also used frequently in real estate transactions because in real estate, like-kind requirement is easy to satisfy.
Types of 1031 exchanges
There are several types of 1031 exchanges.
- Most commonly used is Forward Exchanges. First, a person sells one or more pieces of property. The proceeds are held by an intermediary. Then the seller identifies one or more replacement property(ies) within 45 days. Finally, he/she completes the purchase of the replacement property(ies) within 180 days after the initial sale.
- Reverse Exchanges are used most commonly when the person is unable to identify and/or acquire replacement property within the 45-day and/or 180 day period. Under this scenario, the person buys a new property first and sells an existing property second.
- Improvement Exchanges (or Construction Exchanges) are similar to Forward Exchanges except the person wishes to make capital improvement to the replacement property with funds from the exchange account. In this case, the intermediary will take title to the property and will make payments to third party contractors until the exchange is finished. After the complete of the construction, the property will be titled back to the person.
- Parking Exchanges are for big commercial, retail, and industrial development that cannot be completed within 180 days. With carefully structured “parking exchange,” the 180-day period can be extended over an unlimited period.
- There are also Foreign Exchanges, Personal Property Exchanges, and exchanges deals with partnership.
Exchanges are easy to mess up. Therefore, before you start the move, please consult an attorney or CPA who is experienced in this practice. You can also consult Lei Jiang Law Firm for any questions regarding this subject.