Investing in Real Estate: How Does a 1031 Exchange Work?

bottle full of coins with greenery

bottle full of coins with greeneryWith a Section 1031 Exchange, also commonly known as a like-kind exchange, you have the chance to defer your property sale taxes by exchanging your investment property for someone else’s property that’s similar to yours.

According to IRS rules, the property you got in exchange would be considered as a continuation of the investment property you exchanged. This results in the IRS postponing your gains taxes, which means that you defer paying taxes on the profit you obtained from the exchange, but get to own new property.

Basic Example of a 1031 Exchange

Let’s say you traded a rental home that has an adjusted basis of $300,000 for another investment property. So both properties’ fair market value is $600,000. And since the basis of your new property, which is $300,000, is equal to your old property, there’s no recognized gain for the transaction.

To benefit from a 1031 exchange, the IRS states that you might only trade property for another property similar to yours, called “like-kind” properties. Investment expert 1031 Exchange Place says that 1031 exchange properties have a similar character or nature, even if they have varying qualities or grades.

Generally speaking, all investment properties in the U.S. are deemed like-kind with other properties in the U.S., regardless of location or type. For instance, an office building in Utah is like-kind to a rental building in San Francisco.

What’s Not Covered

If you continue trading an investment property for another with the same value, you won’t ever recognize gains that you would need to pay taxes on. However, if you sell your exchanged property to obtain cash, your original deferred gains, along with any extra gains would be deemed taxable by the IRS, because the succeeding transaction, involving cash, won’t be covered under the IRS’ 1031 exchange rules.

By entering into a 1031 exchange, you could trade properties to raise or reduce your exposure to specific property sectors, while also deferring capitals gains taxes until such time that you sell your properties for cash.

Understanding the game of property investment and the rules set forth by the IRS, 1031 exchanges are an excellent way to rebalance your property investment portfolio.