By Lindsey Weidenbach

If you’ve ever bought or sold investment property, you’ve probably heard of a “1031 exchange” which is an IRS-blessed way to defer taxes when you sell certain types of real estate and want to invest earnings in other properties. This tax deference is often advantageous, however, the pros should be weighed against the cons prior to diving into a 1031 exchange.

Who can perform a 1031 exchange

You benefit from a 1031 exchange if you are selling investment property, or real property that is used in a trade or business, and in turn want to purchase new investment property to replace it. If this is the situation, you can sell the old property and purchase the new property without paying any taxes. This tax deference is the main benefit of a 1031 exchange.

Other requirements of the 1031 exchange include:

• Use of the property that you’re selling (the “relinquished property”) has been as an investment or in a trade or business for at least 5 years. 

• Once you sell the relinquished property, you have 45 days to identify new property (or properties) to purchase (the “replacement property”) which also must be intended for investment, or for a trade or business purpose. 

• After the replacement property is identified, it must be purchased within 180 days (approximately 6 months) from the relinquished property's date of sale. 

• The exchange must be handled by a qualified facilitator as defined under the Internal Revenue Code.

• The “exchangor” (the person selling and buying properties) cannot hold any of the sale proceeds at any time – you must engage the facilitator prior to the sale of property. 

 Who should perform a 1031 exchange

When determining whether a 1031 exchange is right for you, you should look at your basis in the property that you’re selling. A 1031 defers taxes, but it causes a carryover in basis (basis being the difference between the price you purchased the property for and its current fair market value).  Meaning that your basis in the property that your selling becomes the basis in the property that you’re purchasing.

If you have a high basis in the property, then you might not want to defer taxes and it may be more tax efficient to pay the capital gains now, while rates are reasonable. However, if you have a low basis in the property, it is almost always more advantageous to defer the taxes and go with a 1031 exchange. We recommend having your accountant run the numbers to see what the tax hit would be if you sold the property and paid the tax and then determine if a 1031 exchange is for you.

Types of Exchanges

The exchange identified in the bullet points above is what we call a “forward exchange” and is the most common type of 1031 exchange.  Other exchanges include:

• A multiple property exchange: You can sell and/or purchase multiple properties within an exchange, so long as each property meets the qualifications.

• A reverse exchange: You can first purchase the replacement property and then sell the relinquished property

• A construction exchange: You can sell one property, purchase another and build improvements on it, all using exchange proceeds.

Any 1031 exchange is highly technical. A misstep of the Internal Revenue Code regulations can lead the disqualification of your exchange. Gatens Green Weidenbach in known for its real estate focus and regularly acts as a 1031 exchange facilitator.

Contact us if you have questions or want to learn how we might work together.