Simply stated, a 1031 Exchanges allows you to sell an investment property and roll the funds into another investment property while deferring capital gains taxes. This is a great tool and most investors are very familiar with it. If you aren't read on.
I am in the middle of an exchange right now and closed one last month so while they aren't the bread and butter of my business I do a lot of them. Savvy investors always look for ways to maximize their gains and the 1031 is a tool in their tool box. Why is it called a 1031? It gets its name from Section 1031 of the U.S. Internal Revenue Code. What, specifically, does it do? The tax code spells out an allowance for investors to defer capital gains taxes when selling investment or business property and reinvesting the proceeds into a similar "like-kind" property. Like-kind is very broad and really as long as the real property is still being held as an investment it will qualify. No, your primary residence doesn't qualify unless you have rented it out for at least two years to demonstrate it is now a rental property. Remember once you convert it to an investment for this sale you lose the home owner's exemption though because it is no longer your primary residence. (You can convert it back to your primary residence but that is a topic for a future blog post!)
There are some rules for the exchange, however. While you can buy your replacement property then sell your old property, we more commonly see a traditional exchange whereby the seller closes escrow on their sale (it must be set up as an exchange before close of escrow) then they have 45 days to identify their replacement property. (They actually can identify up to 3 properties but have to close escrow on at least 1 of them.) They then have to close escrow on the new property or properties by day 180 after their initial sale. The value of the replacement property or properties must be equal to or of greater value than the sale property (minus non-recurring closing costs) to avoid capital gains taxes. Also note the debt of the sale property must also be replaced with a new loan or cash so the total replacement amount is the same as the sale. If you buy something of less value you are only taxed on the difference, also called the "boot."
If you inherited a property and have been renting it but want to get into something else this is a great strategy. Call me if you want to discuss a 1031 and how it can benefit you. (Photo of Christopher Astillero of Exchange Resources, Inc. in Rancho Bernardo.)
