What is a 1031 Exchange?


The “1031 Tax Deferred Exchange” is a powerful tool for real estate investors and it takes a qualified real estate agent to guide clients correctly. Denice has choosen to specialize in this unique area of real estate and I recommend her highly. – Bill Townsend, VP Starker Services Inc.

What is a tax deferred exchange? Internal Revenue Code Section 1031 has been a part of the Tax Code in one form or another since 1921. It allows taxpayers the opportunity to defer capital gains taxes owed upon the sale of investment or income property (not your personal residence) by exchanging the property for other like-kind property. The IRS states specific guidelines that must be followed and a Qualified Intermediary provides for a safe harbor exchange by assuring adherence to these guidelines. A myriad of court cases and IRS rulings have established the definition of “like-kind” real estate to be very broad so ask a Qualified Intermediary if you’re in doubt. A Qualified Intermediary is a professional company that specializes in processing §1031 exchanges. A Qualified Intermediary must be retained prior to the closing of the exisiting property. There are many types of exchanges so a Qualified Intermediary can help determine what’s best for your situation.

What is capital gains tax? Currently the rate is 15%. Capital gains is the difference between what a property sells for and the “adjusted basis” in the property. It’s complicated stuff for the numerically challenged. When investment property is purchased, the purchase price becomes the initial cost basis. If you make capital improvements to the property, the cost of those improvements will increase the basis in the property, adjusting the basis upwards. Depreciation is a benefit to owning investment property which allows for a yearly deduction of a portion of the value of the property improvements. Give it a try, click here to calculate your capital gains tax. (note: Depreciation cannot be taken on land).

Isn’t capital gains tax only 15%? No. Gain from appreciation (the increase in your property value) is taxable currently at a maximum of 15%. However, the gain from the depreciation is taxed at 25% depreciation recapture. In addition, most states will charge state tax as well (Washington is not one of them).

Is it possible to avoid paying capital gains tax, like, forever? With proper estate planning, you may never pay capital gains tax. There are many tax-planning vehicles that allow taxpayers to relinquish their low basis assets (such as real estate) without paying taxes. Gifts to loved ones, charitable contributions, and certain irrevocable trusts are just a few options available to savvy investors. Even without a complex estate plan, any property included in a descendant’s gross estate will be transferred to their heirs with a basis “stepped-up” to fair market value. This means that all capital gains in the property will be forgiven, provided the estate’s value does not exceed the statutory exclusion limitations.

How the exchange process works: Upon closing the sale of the relinquished property, you must adhere to two timetables which both begin on the date the existing property is transferred.

First, you must identify in writing possible replacement properties within 45 days of the closing. The Qualified Intermediary will provide you with a form on which you may list up to three potential replacement properties of any value. Once you have completed the ID form, you must fax or mail it to the Qualified Intermediary by midnight on the 45th day.

Second, you must acquire at least one of the identified properties prior to the expiration of the 180 day replacement period. Again, this period begins on the day the relinquished property is transferred. You may buy more than one of the identified properties provided they all close before within the 180 day period.

The inability to acquire any of the identified properties will cause an exchange to fail. There is no mechanism for alternative property selection once the 45 day identification period has elapsed.