1031 Exchange Information

What is a 1031 tax exchange?

You may have heard of people "exchanging" their investment property to avoid paying substantial taxes on their sale proceeds. An exchange of real property can be a valuable tool to defer or avoid excessive capital gains taxes on real estate transactions.

Section 1031 of the IRS Code offers real estate investors a great investment opportunity to build wealth and save taxes. By completing a 1031 exchange, you can dispose of investment property, use all of the equity to acquire replacement investment property, defer the capital gains tax that would ordinarily be paid, and leverage all of your equity into a replacement property.

Replacement property acquired in an exchange must be similar to the property being sold. Here are some examples of properties that might be eligible for a Section 1031 exchange:

* Single Family Rental
* Multi-Family Rental
* Farm or Ranch
* Raw Land
* Retail Office Building
* Motel or Hotel
* Golf Course
* Industrial Property
* Lease of 30 years or more

Properties NOT eligible under Section 1031 include foreign property and your primary residence.

Why exchange real property?

To save taxes, yes, but said more succinctly, to build your estate with pre-tax dollars. Using proper exchange techniques will result in what is effectively interest free money from the government. Taxes you owe can be paid later, allowing you the use of that money today to buy more or more expensive investmentproperty.

Other reasons to exchange include:

- Increasing depreciable basis by acquiring property encumbered with a larger debt.

- Acquiring sheltered income by exchanging for unimproved land for improved property.

- Acquiring property without cash, when sales may be impossible.

- Consolidating assets by exchanging many properties for one larger property.

- Receiving nontaxable cash by exchanging and refinancing after and independent of the exchange.

- Diversifying holdings without tax consequence.


Example of how not paying the taxes will allow you to build your estate faster:

If you acquired an investment property for $50,000 and sold it for $150,000 you would have a $100,000 capital gain (that is not including the gain you would realize because of depreciation taken during the holding period of the property, which lowers the basis and results in higher realized gain). After taxes (30% for the purpose of example, state and federal), you would end up with $70,000 to do what you like with, but let's assume you will use it as a down payment in another property.

Sell $150,000
Buy $ 50,000
Gain $100,000
Tax Bracket 30%
Tax $ 30,000

Balance to invest: $70,000

Taking that $70,000 and leveraging it 4 to 1 would result in a purchase of a $280,000 property. 10% annual appreciation in year one would result in an equity increase of $28,000

If you structured the sale in accordance with section 1031, and did not have to pay the taxes at the time of the disposition of the first property (exchanging it instead of selling it), you could invest the entire $100,000. Leveraged at the same 4 to 1 ration would allow you to purchase a $400,000 property. At the same 10% rate of appreciation, your increase in equity in year one would result in a $40,000 increase in equity. Multiply this added $12,000 equity buildup over a 20 year investment horizon and the result is substantial.

Property of "like kind"

Internal Revenue Code Section 1031 says no gain or loss shall be
recognized (taxed) if property held for investment is exchanged solely for a property of like kind to be held either for:

1. Production of income
2. Investment
3. Productive use in trade or business

Property must be of "like kind." This means real property for real property, personal property for personal property. "Like kind" is broadly defined, that is, all real estate qualifies regardless of the "grade or quality." It is the "nature or character" of the property (realty or personalty) and not the name of the improvements (office building, apartment, hotel, etc) that determines "like kind". This was emphasized in Commissioner of Internal Revenue v. Chrichton.

This case involved the exchange of mineral interests and improved real property. The mineral interests were held to be like kind property because under state law they were considered real property. In a subsequent revenue ruling, the IRS indicated that water rights also met the like kind test.

Property not qualifying

1. Stock in trade
2. Partnership interests
3. Stocks, bonds, notes
4. Dealer property

Multiple Properties

Nothing in Section 1031 prevents a taxpayer from exchanging out of or into multiple properties.

Tax Consequences

Exchanges can be fully deferred or partially deferred. Any unlike kind property received in the exchange is considered boot and is recognized (taxable) in the year of the exchange.

Boot is:

1. Cash or the equivalent of cash
2. Any unlike kind property
3. Mortgage relief
4. Any combination of the above

Cash paid offsets mortgage relief boot. The lower of the gain or the boot is taxable in the year of the exchange.

For a completely tax deferred exchange you must trade up in equity, value, and loan.

Basis of Property Received

This is referred to as substitute basis and is the Fair Market Value of the property received minus the deferred gain (or plus any deferred loss).

The Exchange Process

During the real estate sales transaction, it must be disclosed to all parties (the Buyer) that the Seller intends to exchange the property. There is normally no impact to the Buyer, but it must be disclosed in writing prior to the close of escrow.

Two Party Exchange

As mentioned before, to structure a completely tax deferred exchange, the investor must acquire property (properties) with equal or greater equity and a larger fair market value than the property transferred (up in equity and value). This assumes that there is gain realized and that the taxpayer pays boot and assumes a larger loan.

The very common three party exchange is comprised of a sale and an exchange, or an exchange and a sale.

At Rogan and Associates, we hope you find this useful in your search for Fallbrook Real Estate.

Maggie Rogan
Maggie Rogan
Broker Associate
California DRE License #02056729 Fallbrook CA 92028