Tax-Deferred Real Estate Swaps: Understanding 1031 Exchanges

The attorneys at Azrael Franz Schwab Lipowitz, LLC discuss the details and benefits of 1031 real estate exchanges.

A 1031 exchange, named for Internal Revenue Code Section 1031-C, allows an investor to defer capital gains taxes on the sale of a property by reinvesting those proceeds in another investment property.  The following is an explanation of some of the important terms and details of a 1031 exchange.

1031 exchanges are for investment properties only and not properties for personal use. Although the definition of “property” in a 1031 exchange is not limited to real estate, the vast majority of 1031 exchanges revolve around real estate transactions.

The financial advantages involved in a 1031 exchange can be substantial.  Instead of paying a large percentage of the sale price in capital gains taxes, an investor can use that money as leverage towards the purchase of a more costly property.  A 1031 can be a powerful tool for an investor’s portfolio growth and return on investment.

What kind of property can be exchanged?  The term used by the IRS is “like kind,” but this carries a broad definition.  Most types of real estate will qualify even if they’re for varying uses. For example, an apartment building for a retail center, or raw land for an office complex.

A common question for many is in regard to timing, and how an investor is expected to locate a property for exchange at just the right moment.  The 1031 rules answer this need in at least two ways.  First, the exchange does not need to be direct.  If a suitable property for a direct exchange can’t be found, a third party can hold the proceeds from a sale and like term for the later purchase of an exclusive property.  The IRS allows up to three properties to be designated as replacements, as long as one of them goes to closing (within certain valuation tests, an unlimited number of replacement properties may be designated).  Closing on the new property must occur within six months of the sale of the old property.

A final and important note is that not all proceeds are necessarily tax-deferred.  Any cash received by the seller will be taxed, generally as a capital gain, if they are not used to purchase an exclusive property.  Likewise, any reduction in mortgage loans or other debt as a result of the swap is taxable.  Essentially, any reduction in the investor’s liability relating to the property will be taxable as income.

Questions about a 1031 exchange or other real estate tax law matters?  Contact the attorneys at Azrael Franz Schwab Lipowitz LLC.