1031 Tax Exchange

A 1031 tax exchange is really a deferred tax exchange. What this means is that it isn't a way to eliminate taxes, but to defer them or put them off when you re-invest your money into another property.

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.

So if you bought a house, sold it and re-invested the money in another house, you would not have to pay the capital gains from the first house. If you then sold the second house and did not re-invest the money you would then have to pay the gain from the first house and any gain on the second house as well.

The reason the IRS allows 1031 tax exchanges is because when you re-invest the money into another property, your gain is on paper and not in a way that pays for the taxes. In other words you have a "paper" profit and not the cash in hand to pay taxes. So they allow you to put off paying the tax due until you do have the cash in hand. I love this feature and I believe it is really smart for the IRS to allow this.

Why You Should Use 1031 Tax Exchange Forms

• You can acquire properties more easily by keeping your money instead of paying a portion to Uncle Sam and then re-investing what is left.

• You are in essence getting a loan from the government interest free for what you would of had to pay in taxes.

• It allows you to reallocate your portfolio of properties without paying any taxes due when you sell.

1031 Tax Exchange Rules

• The value of the replacement property must be equal to or greater than the value of the relinquished property.

• All the equity received from the sale, of the relinquished real estate property, must be used to acquire the replacement, "like kind" property.

• It must be a "like-kind" exchange.

• The funds must go through the hands of a qualified intermediary and not your hands or youre agents. Basically, the IRS wants to know that you didn't get any cash and to ensure that you don't, they don't want you to touch the funds.

• The debt on the replacement property must be subject to an equal or greater level of debt than the property sold or as a result the buyer will be forced to pay the tax on the amount of decrease. If not he/she will have to put in additional cash to offset the low debt amount on the newly acquired property.

• You have exactly 45 days to identify your replacement property after selling the first property. There is no extension whatsoever, even if the 45th day is a saturday or sunday or holiday.

• You have 180 days to close on the replacement property, again no extension is allowed.

The biggest challenge with doing a 1031 tax exchange is the time limits. Identifying a replacement property within 45 days can be difficult. Especially if you hold a full time job and do not focus all your time on your investing. Still, I contend that they are extremely beneficial.

By the way, you cannot do this with stocks or bonds, which is why even though I invest in those things as well, I still like real estate investing the best!

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