1031 Exchanges - Are They Right For You?

A 1031 Exchange is a way to exchange certain types of properties to defer or prevent capital gains taxes. The "1031 Exchange" name comes from the Internal Revenue Service code which states, "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment." What does this mean to you?

Here is an example of how a 1031 Exchange works. Jack buys a duplex for $250,000. After 4 years he could sell the property for $375,000. The substantial gain of $125,000 is subject to capital gains taxes when the property is sold. However, if Jack invests the sale earnings into another property, then he can avoid paying the capital gains taxes.

If you are a "Buy and Hold" investor using 1031 Exchanges can be a profitable investment strategy for the long term. "Buy and Hold" investors typically buy a property, rent it for a small income, hold on to it for appreciation and eventually sell at a considerable profit. Every sale of property is re-invested thus circumventing the capital gains taxes.

"Buy and Flip" investors have a more difficult time using the 1031 Exchange as part of their strategy. The IRS 1031 Exchange code states that both properties that you are buying and selling must be held as an investment or used in a business. Therefore, when you buy, fix up and "flip" the property, the IRS considers the property a resale which does not qualify for the 1031 Exchange.

As long as you hold a property for a year plus one day you can qualify for a 1031 exchange. Renting out the property can also provide some passive income in the meantime.

If you are considering a 1031 Exchange for your next deal, we highly recommend you consult with a tax attorney and a 1031 expert.