Build Wealth that is Tax Deferred
Real estate investors who are clever know how to use the provisions of the Internal Revenue Section 1031 to make a property “exchange” that qualifies for a tax exemption.
Using the provisions of the IRS rules under 1031 exchanges allows a real estate investor to make a similar investment in “like” property during a limited period of six months and not have to recognize any profits in the transaction.
This allows the real estate investor to defer all taxes, including any capital gains.
The IRS rules regarding 1031 exchanges say that no gain or loss is recognized if an exchange of a property occurs, that is used in trade, for business, or for investment, when the property is exchanged for a property of the “like-kind” that will be used in trade, for business, or for investment.
Here is an example of how powerful this provision of 1031 exchange really is in direct application:
If an investor sells a property, without buying another one of “like kind,” they must pay capital gains taxes. Imagine the real estate investor realizes $1 million in profit from the sale of a property and then pays 15% capital gains of $150,000 in taxes based on the profits from the sale. After this tax event, the investor has only $850,000 to invest.
If the same investor uses the provisions of IRS section 1031, the full $1 million is available to invest and there is a tax savings of $150,000.
This allows the investor to preserve capital and continue to build wealth without having to pay taxes until later.
The key to making the 1031 exchange strategy work for any real estate investor is to capture the asset appreciation and use it to buy up into a higher valued property that is a “like exchange” and defer taxes well into the future.
1031 Rules
To be in compliance, it is important to follow the IRS rules of 1031 exchanges very carefully. Cornell Law School has a clear explanation of the rules at https://www.law.cornell.edu/uscode/text/26/1031.
The IRS 1031 covers not only real estate but also stock, bonds, notes, securities, interests in partnerships, certificate of trusts and other beneficial interests.
The limit for like exchanges is 180 days after the original property is sold or transferred.
Conclusion
A 1031 tax exchange is a very effective way to build up value in a real estate portfolio without having to pay tax on the increased value. Real estate investors who are clever take advantage of this tax deferral program to continue to build value in their real estate portfolio without having to pay any taxes on the increased valuations.
It is important to follow the rules accurately in order to take advantage of the IRS 1031 exchange regulations. Timing is critical and 180 days is the limit for an exchange. The property exchanged must be of “like-kind,” yet this definition is very liberal. Some investors use intermediaries to hold funds from a sale until they find a “like-kind” property to make a new investment.