1031 Exchange Basics
Thanks to IRC §1031, a properly structured exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC §1031 (a)(1) states:
"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."
To understand the powerful protection an exchange offers, consider the following example:
- An investor has a $200,000 capital gain and incurs a tax liability of approximately $50,000 in combined taxes (depreciation recapture, federal and state capital gain 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 above example demonstrates, exchanges protect investors from capital gain taxes as well as facilitating significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the IRC. For instance, an accurate understanding of the key term "like-kind" - often mistakenly thought to mean the same exact types of property - can reveal possibilities that might have been dismissed or overlooked.
The benefits of IRC Section 1031 exchanges can be tremendous! Investors are often able to defer thou-sands of dollars in capital gain taxes, both at federal and state levels. If the requirements of a valid §1031 exchange are met, capital gain recognition will be de-ferred until the taxpayer chooses to recognize it. This essentially results in a long-term, interest-free loan from the IRS.
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