Getting taxed on your capital gains is a part of life, but a 1031 Tax Deferred Exchange can help you keep your money. Never heard of this exchange before? Seem confusing? The concept is actually fairly straightforward and extremely useful when dealing with capital gains from property exchanges.

So What is a 1031 Exchange?

A 1031 exchange allows you to sell one of your appreciated assets and defer the payment of capital gains by replacing it with one or more other properties.  It’s essentially a swap on one of your assets.  The concept is fairly simple, but there are requirements to be met before utilizing this tax deferment strategy.

Requirements for a 1031 Exchange:

  1. You will need professional assistance to prepare all legal documents and ensure you are in compliance with all regulations and laws.
  2. The replacement properties must be equal to or greater in purchase value than the sale value of the relinquished property, and you can’t take any cash from the closing.
  3. Both the relinquished and the replacement properties must be held as a rental, investment property, or used in your trade or business.  They cannot be held for personal use, inventory, partnership interests, stocks, or bonds.
  4. You have 45 days after the sale to identify the potential like-kind properties being considered and an additional 135 days (for a total of 180 days) to complete the exchange by acquiring the replacement property.

1031 exchanges are extremely useful, especially if you have a wide real estate portfolio.  The two structures for this exchange are either forward or delayed. A forward structure means you find your replacement property first and then sell your asset.  Delayed is the opposite: you find your replacement property after you sell your asset.

It should be noted that this exchange doesn’t mean you will never pay taxes on the capital gains.  You will have to pay these taxes when you make your final disposition and do not replace it- hence the tax is getting deferred until a later date.  Also remember that the capital gains you receive will reduce the basis for your replacement property.

Finally, you will need to know how a cash and mortgage boot works to take advantage of this exchange. If the amount of money you receive is more than the amount of money you give up, you will have to pay taxes on the difference as a cash boot.  A mortgage boot works the same way; however, instead of paying the difference you have to invest the difference into the new property. These two boots are used because it is extremely hard to find properties with the same exact values.

Overall, 1031 exchanges are an extremely useful tax deferment strategy and can help simplify the taxes paid on capital gains.  At Shea Labagh Dobberstein, we have tax specialists that can help answer any questions you may have.