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A 1031 exchange provides a means of diverting funds from one property directly into the purchase of another like-kind property, deferring capital gains taxes until that new property is sold, or that property may in turn be the subject of a 1031 exchange sale as well to defer the tax burden yet again.

To understand the powerful protection a 1031 exchange offers, consider the following example:

• An investor has a $200,000 capital gain and incurs a tax liability of approximately $70,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold. Only $130,000 remains to reinvest in another property.
• Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property.
• Now if that same investor chose to utilize a 1031 exchange, they would now be enabled to reinvest the entire $200,000 of equity into the purchase of a new valuation of $800,000 in real estate, assuming the same down payment and loan-to-value ratios.

As the above example demonstrates, a 1031 exchange protects investors from immediate capital gain taxes as well as facilitating significant portfolio growth and increased return on investment.

Key points regarding a 1031 exchange

• Investment Property, Not Personal - A 1031 exchange is for investment and business property, not personal property; you can’t exchange your primary residence for another. Some exchanges of personal property (for example a painting) may qualify, be sure to work with a 1031 exchange company to fully understand the process and if your property and target property are in compliance to meet the 1031 exchange guidelines.
• Like-kind is a broad definition - “Like-kind” doesn’t mean that you have to exchange similar properties. You can exchange an apartment building for raw land, or a ranch for a strip mall, the rules are somewhat liberal and should be reviewed before going to market with your 1031 exchange partner.
• Delayed Exchanges are OK - Classically, a 1031 exchange is a simple swap of one property for another between two people. But the odds of finding someone with the exact property you want, who wants the exact property you have, are slim. For that reason, the vast majority of exchanges are delayed, three party, or “Starker” exchanges (named for the first tax case that allowed them).
  In a delayed exchange, you need a middleman who holds the cash after you “sell” your property. The middleman, usually a qualified intermediary or 1031 exchange company, then buys the replacement property for you using the escrowed cash. Subject to time limits noted below, this three-party exchange is treated as a swap.
• Designating Replacement Property - There are two timing rules that must be observed for a delayed exchange. Once the sale of the investment property closes, the intermediary or 1031 exchange company receives the cash. Within 45 days, you must specify the property you want to acquire in writing to the intermediary. You can designate three properties so long as you eventually close on one of them. Alternatively, you can also designate more properties if you come within certain valuation tests.
• Close Within Six Months - Once a property or properties are designated, you must close on the new property within 180 days of the sale of the old property. Start counting when the sale of your property closes, the 45 days and 180 days run concurrently. Designate replacement property within 45 days, and you have 135 days left to close on the replacement property.
• Cash is Taxed - If you have cash left over, the intermediary pays it to you at the end of the 180 days. That cash is called “boot” and is taxed, generally as a capital gain.
• Beware Mortgages - You must consider mortgage loans or other debt on the property you relinquish, and any debt on the replacement property you acquire. If you don’t receive cash back but your liability goes down, that too will be treated as income just like cash.

If you have additional questions regarding a 1031 Tax Deferred Exchange or would like a referral to a company we partner with that will manage the exchange process for you, be sure to let us know and we'd be happy to provide you with further reference material or referral companies.