How a 1031 Exchange Can Increase the Return on the Sale and Purchase of Investment Property

Most people have heard the term “1031 Exchange” mentioned, but many are unclear on how they can benefit from it.  Some think that it is only used by multi-million dollar investors.  Others think that you can only exchange a tract of land for a tract of land or an office building for an office building, etc., but both of these assumptions are untrue.  It is a tool that can be used by both large and small investors to increase their return on their investment.  Land can be exchanged for land, but it can also be exchanged for an office building, a rental house, or a retail building just as long as it is real property and held for investment.  Another common misconception is that you can exchange a personal residence for investment property.  It can only be investment property for investment property.

One of the main benefits of a 1031 Exchange is that it defers capital gains tax.  If you have a property that you may have owned for a long time and it has a very low “basis”, a 1031 Exchange could be of great benefit to you if you plan on moving that investment to another type of real estate, such as land to office building or office building to land or even development land to timberland.  The 1031 Exchange allows you to transfer the original “basis” in the presently owned property to the new property deferring the need to pay capital gains tax on the difference between the “basis” value and the value transferred.  This allows you to transfer capital gain equity from one property to the next on a dollar for dollar basis, rather than having to deduct for the capital gains that you would have to pay on your sale.

How can I do a 1031 Exchange?  Very few exchanges are “direct”, one property for another property.  Most are three party exchanges or non-simultaneous exchanges.  However, the IRS has very specific rules that must be followed to qualify and should only be done with the advice of knowledgeable professionals.

The following is an illustration of the process of a 1031 Exchange:

  • The Seller puts their property on the market with the intention of doing a 1031 Exchange.
  • When a contract to purchase is received, a contingency is included in the contract that the Seller wants to achieve a 1031 Exchange at no additional expense to the purchaser.
  • As settlement approaches, the Seller must arrange with a Qualified Intermediary (QI) and a knowledgeable tax attorney to prepare the paperwork to transfer the proceeds of the sale into a trust to be held for the purchase of the replacement property.  The Seller must not receive the proceeds from the sale.  If he does receive the proceeds, he will no longer qualify for the 1031 Exchange.
  • After the settlement on the Seller’s property, he has 45 days to identify potential replacement properties that may be acquired for him by the QI.
  • Settlement on the replacement property must occur within 180 days of the settlement of the sale of the Seller’s original property.  The proceeds in the trust are used to complete the purchase of the replacement property.
  • The values of the properties involved in the exchange do not have to be the same.  Money may be taken out of the sale which is called “boot” and on which you would have a tax event.  You may also add cash to the purchase side of the transaction to acquire a higher valued property.

1031 Exchanges are a valuable tool which may be used to maximize your buying power and enhance the return on your investment.  They are used for both large and small investments.  Call Grant Massie Land Company for help in evaluating the potential for your property.  Good legal and tax counsel are also needed to evaluate your individual situation.  There is some additional expense, but is minimal compared to the savings that you could realize.  Many 1031 Exchanges are done each year.  It is just another way to maximize your real estate investment.