Trying to understand the 1031 Exchange


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Now that I’ve come out from another harrowing tax season, I thought it would be a good time to think about different ways to make my money work for me. I started talking to my financial guy Garry Yee about real estate, and he brought up the 1031 exchange.

Now, 1031 exchanges aren’t even understood by most realtors, much less lay people like myself, but the conversation was significant enough that I thought I should bring it to light for anyone who has even heard of it and wanted to know more.

Basically, Section 1031 of the IRS Code offers a way for real estate investors to sell one income producing property for another one via an exchange in order to defer a capital gains tax.

In plain English: the IRS allows you to sell your income-generating property, such as a rental house, apartment building, or warehouse, and exchange it during the sales transaction to another income-generating property without a current tax payment due.

What?

“Let’s say you own a rental property outright, that you originally bought for $100,000 and now have it on the market to sell it for $200,000,” Yee explained. “If you sold it outright and took the cash, you would have to pay a capital gains tax of roughly $15,000. You would also have to pay taxes on the depreciation you took on the property for its use over time.

“If you made the sale via a 1031 exchange on another property of the same type and value, you wouldn't pay the capital gains tax until you sold the second property. Your sale for $200,000 would result in a purchase for $200,000 or more on the second property so you have the amount that would have gone to taxes actually helping you purchase more property,” he said.

My understanding is that many realtors will try to exchange a house for a house, or an apartment building for another apartment building. In an exchange, it could be an apartment building for a warehouse or even an office building.

“You have to meet a timeline for all of this for it to all work,” Yee warned. “By using the IRS statute 1031, you have 45 days to identify a property to purchase and 180 days to close on it.”

All good things to consider. I once had a rental property and at the time I had decided to sell, I thought about such an exchange but didn’t understand how it all worked. The main deterrent was needing to find a new property to replace it within the required timeline. At the time, the real estate market had exploded, and it was going to be almost impossible to find something else in the same price range to make it work. But if the conditions are right for me the next time I’m ready to sell a piece of the rock, this may be something to think about.

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