What is a 1031 Tax Deferred Exchange?

A 1031 Tax Deferred Exchange is a tool real estate investors and business owners can use to build their wealth without incurring capital gains taxes. It allows them to protect the profits from the sale of their property and reinvest them in another, all tax free.

Most people who invest in real estate or own property used for business purposes are concerned with the tax ramifications involved in the sale of their properties. If you are one of these people, or if you are considering investing in real estate, you should know about the Internal Revenue Service's provision for exchanging one real estate investment for another. This real estate transaction is referred to as a 1031 Tax Deferred Exchange, and it can help real estate investors increase their assets while deferring taxes.

According to Section 1031 of the IRS code, owners of investment properties or business properties are able to sell their property and buy another without incurring any capital gains tax. This means that a real estate investor can defer, or possibly even avoid altogether, federal, and in many cases state, capital gains taxes. When this is considered, the benefits of a 1031 Tax Deferred Exchange are obvious as compared with the outright sale of an investment property. With proper planning, an investor can continue to exchange properties for those of greater value. They will continue growing their assets while deferring, and in many instances avoiding, taxes.

The IRS does have some rules in place to ensure that a 1031 Tax Deferred Exchange is handled properly. First, there is a limit on how much time can lapse between the sale of the first property and acquiring the next. Once you sell your property, you have forty-five days to provide written notice of properties that have been identified as possible replacements, and one hundred and eighty days to invest the money from the sale of the property into another "like-kind" property. In the instance of a 1031 Tax Deferred Exchange, the IRS considers a "like-kind" property any piece of real estate that is used for productive business purposes. This broad definition leaves the investor with a fairly extensive number of properties to consider, as rental units, businesses, ranches, land and many other types of real estate fall within this category.

A second contingency put in place by the IRS when dealing with a 1031 Tax Deferred Exchange, is that the investor must place the proceeds from the sale of the first property in escrow with a third party until the second property is acquired. This third party is referred to as a Qualified Intermediary. There are many firms that specialize in providing exactly this service to investors interested in taking advantage of a 1031 Exchange. It's recommended that investors retain the services of a Qualified Intermediary prior to the sale of the first property. In addition to holding the proceeds of the property sale in escrow, experienced Qualified Intermediaries can also help facilitate other aspects of the 1031 Exchange.

When planned properly, 1031 Tax Deferred Exchanges can allow investors to increase their assets. Investors can continue to exchange properties for those of increasing values without ever incurring capital gains taxes. A 1031 Tax Deferred Exchange is a great way for investors to protect their profits from the sales of their properties and grow their wealth.