1031 Tax Deferred Exchange

A capital gain is profit from the sale of property or from an investment.

The sale of a rental property generally triggers capital gains taxes.

A 1031 exchange helps you defer those taxes. It is named after Section 1031 of the Internal Revenue Code.

Typically, 1031 exchanges involve the sale of rental or investment real estate. You can also "1031 exchange" personal property such as airplanes, boats, artwork, livestock, and much more. But we will not worry about exchanging cows right now.

There are specific requirements you must follow to qualify for tax-deferred exchange treatment. In order to defer all of your taxes, you must reinvest in another property of equal or greater value. You must also identify your replacement property and complete your exchange within specific time frames.

From when the relinquished property closes, the Exchangor has 45 days to identify potential replacement properties and 180 days to acquire the replacement property. The exchange is completed in 180 days, not 45 days plus 180 days.

Here is why this is a good thing to do.

An investor has a $200,000 capital gain and incurs a tax liability of approximately $70,000 in combined 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, however, he or she would be able to reinvest the entire $200,000 of equity in the purchase of $800,000 in real estate, assuming the same down payment and loan-to-value ratios. 

As the example demonstrates, you get to build your wealth faster by keeping all of your money working for you instead of paying taxes. The government does this so that people will invest in real estate and therefore be more invested in the community.

In summary, a 1031 exchange is a way to defer the payment of these taxes. That is why it is referred to as a “1031 tax-deferred exchange”. (Sometimes people say “tax-free exchange”, but that is not accurate, as the tax is deferred until the day you sell the property and do not invest the money into a new one.)

This is not the easiest thing to do, which is why you see many promotional videos and ads with really boring lawyers droning on about why you should hire them to do an exchange. And maybe you should use them. But for now, let's get past the real estate exam.