A 1031 exchange (IRS Code Section 1031) gives an option to the investor by reinvesting the proceeds from the sale of investment property (known as the “relinquished property”) into qualified replacement property to defer capital gains tax. The net result is that the exchanger can use 100% of the proceeds (equity) from their sale to buy another property and defer the capital gains tax.
Property involved in a 1031 tax deferred, like kind exchange must be held for productive use in a trade or business, income production (rental) or investment purposes.
1031 “Like-Kind” Exchange Explained
1031 Like Kind Exchanges originally began as 1031 Tax Swaps of properties between two parties, often farmers trading parcels of land with one another. Over the past 20 years, the regulations regarding 1031 exchanges have become clearer and now allow investors to conduct 1031 Exchanges with more guidance. Today, 1031 tax-deferred exchanges are used by both corporations and individual property owners as part of their investment strategy.
A 1031 Exchange can potentially provide real estate owners with greater leverage, increased diversification, improved cash flow, increased potential for geographic relocation and potential property consolidation. However, there is no guarantee that these objectives can be met. As with all real estate investments, there is a degree of risk.
The strict identification and timeline rules laid down by IRS must be followed during a 1031 tax-deferred exchange. It can be a powerful wealth building tool. To ensure that every requirement of Section 1031 is met, a professional tax advisor should be utilized. Failure to do so can result in associated penalties plus immediate tax liabilities.
1031 Exchange permits investors, in addition to tax deferral, to purchase a leveraged replacement property and thus increase their basis in the amount of additional debt assumed. This can shelter as much as 50% to 60% of the rental income cash flow from income taxation. The after-tax return on investment on an annualized basis can be even greater because of the possibility of additional return from appreciation of the property.
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