1031 Exchanges

The provision in the tax code, Section 1031, is one of the most powerful tax-deferral strategies that anyone involved in real estate investments can take advantage of.  In fact, even the regular home-owner who wants to acquire a new property in exchange for his existing real estate is bound to benefit from this provision.  It is no wonder then that a lot of real estate consultants, lawyers, and even accountants advise their clients to take advantage of this benefit.

The 1031 exchange basically allows any investor to sell any real estate property that is used for business and investment purposes without paying any amount of tax. But the catch in this provision is that you need to find a replacement property to replace your relinquished property. In addition, the property you must choose must be of like kind. Now many people are confused about this condition. “Does like kind mean I need to purchase another 2-bedroom apartment if I sell my existing 2-bedroom apartment?” Well, the answer in this case is no because that would counteract the purpose of the 1031 exchange provision if it had this kind if limitation.

By being like kind, the provision simply means that you cannot exchange a residential real estate property with a business property and vice versa. So this should pose no problem to people who want to relocate their business or establish their business at a better location. You should note though, that your replacement property is subject to tax if you decide to sell it in the future without a replacement.

But if there are advantages you will derive from the 1031 exchange, there are bound to be some disadvantages as well. Some of these disadvantages include having a reduced basis with regards to the depreciation of the replacement property. This is because the tax basis for the replacement property is basically the purchase price of the said properly minus any gain that has been deferred from the sale of the relinquished property. Therefore, the replacement property will have a deferment that can be taxed when you decide to sell this property in the future. You should not let this drawback discourage you from taking advantage of the benefits from the 1031 exchange provision though, because the advantages far outweigh the disadvantages.

Then there are 1031 exchange techniques you need to be aware of because there are many ways for 1031 exchange transactions to be made possible. This is because in 1991, the Internal Revenue Code was revised to include the “safe harbor” procedures. Some of the things that were added include the use of an intermediary, the use of an escrow account to be used as temporary holdings for the funds, direct deeding, and other kinds of alternative procedures. It is strongly recommended that you structure your 1031 exchanges in compliance to the changes made in 1991 but some of the said aspects may not be a necessity in your case. For example, some transactions may not need the services of the said intermediary because both parties that are involved in the transaction agree to just have an exchange agreement with each other.