In filing your personal tax return, you should take advantage of as many tax breaks as possible to reduce your tax liability and maximize your tax refund. This may be done in a number of ways. One of which is a 1031 exchange.
A 1031 exchange is a tax shelter named after the portion of the Internal Revenue Code in which it is located, IRC § 1031. This is also known as a like-kind exchange and may be a beneficial way to avoid realizing capital gains or losses on the sale of an investment.
Basically, if an investment is held for the productive use of a business or trade, and meets other requirements, the investment may be exchanged for a like-kind investment of equal or greater value. However, this does not apply to stocks, bonds, notes, other securities, interests in partnerships, certificates of trust or beneficial interest, and similar forms of investment. Real estate is a common area of investment in which 1031 exchanges are utilized.
One of the principal requirements for an exchange to qualify under section 1031 is that both properties must be “like-kind”. Property may be considered “like-kind” if it is similar in character and nature. However, if property being sold is similar to the property being bought, but one is located outside of the United States and the other is inside the country, it does not qualify as “like-kind”. Most real estate is considered like-kind; this is a contributing factor to this being used so much in the sale of real property.
Another condition on 1031 exchanges is that the property must be identified and the exchange completed within 180 days. Therefore, once property is sold, the purchase of the new property must be done within 180 days or you will realize the gain or loss on the initial sale.
All of this may sound very technical, but once you understand the tax benefit, it will be worth the complexity.
Example: Bob has a rental house he uses as an investment property. When he purchased the house, it was worth $75,000. He is unhappy with the part of town the house is in and would like to sell the property. He lists the house and sells it for $100,000 because the market has increased so much. Instead of being taxed on the money he made in the sale of the house, he turns around and buys another rental house in two months for $105,000. Because the property exchange qualifies as a 1031, Bob avoids paying the taxes on the income from the sale.
After 20 years, Bob decides he wants to sell the second rental house because he is relocating. He does so and makes $20,000 on the sale. Again, he rolls the profit into a new piece of real property and avoids paying the taxes on the gain.
The process explained in the above example can be repeated a number of times as long as each exchange qualifies as a 1031 exchange. So, you can defer paying taxes on the gain of the investment for years. However, when it comes time to sell and you do not exchange the property, you will be liable for the gain at that point.
As similar tax shelter exists especially for insurance products, which is a 1035 exchange. This can also be beneficial in avoiding the tax burden from gains.