Tax Deferred 1031 Exchange

The tax benefits of an IRS 1031 Tax Deferred Exchange can be substantial for any investor in real property. The main idea of the 1031 Exchange is to be able to exchange real property (or properties) for "Like Property" (or properties) that may be for one reason or another more beneficial to the investor with taxes deferred on the gains from the sale of the original property.

Here are just some situations where an investor may consider the IRS 1031 deferred tax exchange for exchanging properties for other properties:

  • The  investor has enough equity in a property to be able to divide that equity into more than one property in order to increase his platform for appreciation profits.

    $100k rental home with $50k total equity
    exchanged for
    two other $100k rental homes with $25k equity in each (same $50k total investment).

    With the same investment ($50k) the investor now benefits from annual appreciation
    based on $200k platform rather than $100k - doubling profits gained through appreciation.

  • The investor has moved to a different state and wishes to have his rental properties within the same city investor now resides.
  • The investor wants to exchange one investment property type for another investment  property type.              

    e.g. Investor wishes to exchange land (where the only significant source of profit is appreciation)
    for a rental  property (with potential profits through appreciation, depreciation & monthly positive cash flow).

  • Two or more investors  in a property wish to terminate their partnership. 1031 may be  used in a couple of ways here. The property is sold to a different individual and each  investor then purchases a separate exchange property. Or one investor sells this  ownership to the other investor, then the selling investor purchases a separate exchange property.

Here are some key elements that you need to understand thoroughly.   Keeping a tax professional handy would be very helpful in making sure you follow all the important guidelines in order to best benefit from these investment decisions.

  1. For 1031 Exchanges: You must hold a property for at least 2 years (must be rented at least 14 days and you cannot use it personally more than 14 days within those 2 years).
  2. For 1031 Exchange converted to principal residence:  If you purchase a property through 1031 Exchange and then later move into it and want to sell it and take the homeowner īs exclusion, you must hold it for at least 5 years.  
  3. Those gains will be pro rated as follows
    • If you sell that 1031 property, the gain needs to be prorated between the time you held it as investment and personal. Only the personal gain is eliminated through the home sale exclusion, and the investment portion is taxed. For example, if you sold a home where you had a $500,000 gain, and you had rented it for 2 years and lived in it for 3 years after, then 2/5 of the gain, or $200,000 is taxable as investment, and 3/5 is tax free. If you live there for 8 years after the 2 year rental period (total 10 years owned), then 2/10 of the gain would be taxed and 8/10 excluded. Therefore, the longer you live there, the less is taxed.
    • The tax trap here is if the home was sold before year 5 and you were living there, then the entire gain is taxed! Many investors are falling into it because they rented it for 2 years, then lived in it for 2 more years, or a total of 4 years owned, then selling it thinking they can take the gain tax free since they attained the 2 year principal residence timeframe. However, since they did not own it the full 5 years as now required, it doesn īt qualify as a principal residence or a 1031 as it was personal use at the time of the sale. This is very confusing and a tax professional well versed in real estate taxation should be consulted when shuffling between personal and 1031 properties.

For more information please consult your tax professional.

  1. 1031 Exchange - Main Page
  2. Rate Your Investment Properties
  3. Key Points to a 1031 Exchange
  4. The Meaning of "Like Property"
  5. The Exchange

All information believed accurate but not warranted.

Atlanta Communities