What is a 1031 Exchange?
Understanding Tax-Deferred Real Estate Transactions
Source: LoopNet
A 1031 exchange is a tax strategy used by real estate investors to defer paying capital gains taxes on the sale of an investment property. It involves selling one investment property and using the proceeds to purchase another "like-kind" property. The term "1031" refers to Section 1031 of the U.S. Internal Revenue Code, which outlines the specific rules and requirements for this kind of transaction. By reinvesting the sale proceeds into a new property, investors can essentially continue their investment without an immediate tax liability.
The sale of an investment property usually results in a plethora of taxes coming due for the seller. The transaction often involves capital gains taxes, depreciation recapture taxes, passive investment taxes and, in most cases, state income taxes, and can sometimes add up to 30% of proceeds. But thanks to 1031 Exchange, named after a provision of federal and state tax codes, sellers of commercial real estate can defer these taxes if they instead opt to reinvest the sale proceeds and taxes into a similar property.
A popular strategy that many real estate investors use to lower their tax burdens, a 1031 Exchange, named for Section 1031 of the Internal Revenue Code, involves some technical rules and timelines, but is a relatively straightforward process.
First, the real property being sold must be either held for investment or for use in the taxpayer's trade or business. Second, it must be exchanged for other “like-kind” property.
Defining 'Like-Kind' Property in 1031 Exchanges
The term "like-kind" has a broad definition in the context of a 1031 exchange, concerning the nature or character of the property rather than its grade or quality. Real estate located in the U.S. is like-kind to all other real estate in the U.S., which allows for flexibility in exchanges: a commercial building for a condo, a farm for a shopping center, etc. It's crucial that both the relinquished and the replacement properties are held for investment or used for business purposes to qualify.
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