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Fallbrook Real Estate
Local Area Experts
Fallbrook, Bonsall, Rainbow, De Luz, Temecula Valley & North San Diego County Real Estate
What is a 1031 tax
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?
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
Other reasons to exchange include:
Increasing depreciable basis by acquiring property encumbered with a larger
- Acquiring sheltered income by exchanging for unimproved land for
- Acquiring property without cash, when sales may be
- Consolidating assets by exchanging many properties for one
- Receiving nontaxable cash by exchanging and
refinancing after and independent of the exchange.
holdings without tax consequence.
Example of how
not paying the taxes will allow you to build your estate faster:
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
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
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
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
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.
Nothing in Section 1031
prevents a taxpayer from exchanging out of or into multiple
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
1. Cash or the equivalent of cash 2. Any
unlike kind property 3. Mortgage relief 4. Any combination of the
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.
This is referred to as substitute basis and is the Fair
Market Value of the property received minus the deferred gain (or plus any
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
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
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.