What is a tax-deferred exchange?
A tax-deferred exchange allows a property owner to trade for another similar property or properties without immediately paying federal income taxes on the transaction. Since Section 1031 of the Internal Revenue Code authorizes these transactions, they are also known as 1031 exchanges. Section 1031 states that the IRS will not recognize any gain or loss when parties exchange properties of "like kind" and equal or greater value. Thus, the IRS will not charge any capital gains tax because they do not recognize any gain in the transaction.
What is the benefit of a tax-deferred exchange?
Exchanging one property for another allows a property owner to reinvest more money in a replacement property than using the proceeds from a traditional sale. Owners with highly appreciated property receive the most benefit. For example, if John owns a property worth $1,000,000 with a $200,000 adjusted tax basis, he will pay taxes on $800,000 dollars of gain when he sells it. If the tax rate were 20%, John would give $160,000 to the federal government. That would leave $840,000 that John could invest in a replacement property. On the other hand, if John exchanged the $1,000,000 property for another property, the IRS would not recognize any gain on the transaction. The IRS would not charge any capital gains tax, and John could invest the full $1,000,000 in replacement property.
Use a 1031 tax-deferred exchange when you want to...
- Utilize the equity in a highly appreciated property
- Consolidate or diversify investments
- Obtain greater appreciation on your investment property
- Increase cash flow
- Relocate a business investment
- Transfer into a property with a different tax basis
- Eliminate management problems
