What is a 1031 Exchange?

A 1031 Exchange allows real estate investors to defer the capital gains tax and use the full proceeds from a sale towards the purchase of another property.

What is a 1031 Exchange?

When a property is sold at a profit then the investor(s) have to pay whats known as capital gains tax. A 1031 Exchange allows investors to defer the capital gains tax from a sale of a property and invest the full proceeds into another property.

For example, an investor purchases a property in 2010 for $2,000,000, by 2015 the property appreciates to $2,750,000 and the investor decides to sell. The capital gain from that sale is $750,000, and tax will have to be paid on that gain. 

If the investor decides to utilize a 1031 exchange, they can invest the entire sale proceeds of $2,750,000 into another property and defer paying taxes on the gain.

Benefits of a 1031 Exchange

1031 exchanges can help investors grow their wealth faster because by deferring the capital gains tax, the entire sales proceeds can go to purchasing a larger property.

In the example above, the investor would normally have to pay a tax of $112,500 on the $750,000 gain, leaving him/her with only $2,637,500 to invest in another property. If the investor decides to leverage the property using a typical 75% loan-to-value ratio (LTV), then they can only purchase a property worth $10,550,000, but by utilizing a 1031 exchange they can purchase a property worth $11,000,000 That is $450,000 more worth of property!

Another benefit of 1031 exchanges is the deferred taxes owed to the IRS are erased upon death. Utilizing this strategy can be powerful as investors can use multiple 1031 exchanges to purchase larger and larger properties throughout their lifetime, thus growing their wealth tax free. When they pass away, their heirs will receive the property at whats called a stepped up basis, which is the fair market value of the property at the time of death, thus eliminating the deferred taxes. 

Drawbacks of a 1031 Exchange

There are a strict set rules that must be followed in order to complete a successful 1031 exchange. So while 1031 exchanges can be a powerful tool for building wealth, there are some drawbacks if not used properly.

For starters, a qualified intermediary must be used to handle all the paperwork and hold the sale proceeds during the exchange period. 

The investor will have a 45-Day Identification Period, starting at the closing of the disposed property, to identify up to 3 properties to purchase. If the properties are not identified within the 45 day period then the 1031 exchange is a failure, the proceeds from the sale will be returned to the investor and he/she will be unable to defer the capital gains tax. 

Additionally, there is a 180-Day Exchange period in which the acquisition of the identified properties must be completed. Failure to take ownership on or before the 180 period will result in a failed exchange.

There are also other rules and limitations while attempting a 1031 exchange, so its best to work with professionals throughout the process and start preparing for the exchange prior to the sale of the property you would like to exchange.

Also, if the investor utilizes multiple 1031 exchanges and eventually fails to complete one, the sales proceeds will be returned, and part or all the deferred taxes from prior exchanges must be paid. This can be a pretty hefty tax bill depending on amount and size of the previous exchanges. 

The Bottom Line

If used properly, the ability to defer the capital gains tax and use the entire proceeds from a sale to buy larger properties through 1031 exchanges can be a powerful tool for building wealth over a lifetime. 1031 exchanges can also be used to completely avoid paying the deferred capital gains taxes by passing the property down to your heirs when you pass away.

If you are planning to sell an investment property you own or plan to accumulate properties throughout your lifetime then benefits of utilizing a 1031 exchange make it worth considering.  

Babylon Property Group can assist those looking to start or diversify their portfolio by investing in real estate. For more information please contact us by phone at (631) 253-1609 or email at tcastelli@babylonpropertygroup.com.