1031 Exchange
by Takara Alexis

Established for real estate barons and tycoons, 1031 exchanges have been around since the 1920s. Named for the IRS code which refers to them, the tax-saving tool also known as "flipping" or a "like-kind" exchange has been gaining traction as a way for Americans to save money on taxes from property, by deferring them to another, newly-purchased property.

1031 exchanges are an easy concept surrounded by not-so-simple details. If you own a piece of property, and you wish to sell it and purchase another piece of property of equal or greater value, you can defer your capital gains taxes by performing a "like-kind" exchange.

Both properties must be held for either investment or business use. This can include property that is rented out. Their uses can be interchangeable though. For instance, a piece of raw land can be exchanged for a rental property. Agricultural real estate can even be exchanged for office buildings, apartments, or storage facilities. The like-kind rules are pretty flexible when it comes to exchanges of real estate.

To get a complete deferral of the income taxes, all of the profit made from the previous property has to be immediately re-invested in the new property, which must cost the same or more than the former property. Sometimes this could happen at the same time, but usually a delayed exchange must take place.

Once the former property is sold, the investor typically has 180 days to close on a new one that meets the criteria. During the 180 days, a qualified intermediary must handle all of the assets involved and carefully organize the exchange. You must also specifically identify a replacement property that you plan on buying within 45 days of sale date on the original property. However, you can identify more than one potential replacement within this time frame.

In some instances, you can also flip property the opposite way. If you happen to come across new property you want to buy before you sell your old investment, you might qualify for a "reverse exchange." You still defer your capital gains taxes to your new property; you just do it in the opposite order.

In all cases of flipping, you must have what the IRS has deemed an "exchange accommodation titleholder" who actually holds on to the assets involved in the purchase.

One advantage of the exchange is that in theory, you could avoid paying capital gains taxes forever. If you keep the properties your entire life, upon your death your family may be allowed to sell the property, capital gains tax free. Another important advantage of the exchange is that it provides taxpayers with ability to accumulate additional tax-deferred equity through the use of borrowing, given that the taxpayer continues to reinvest proceeds from sales in property of bigger value.

Because of the complexity of 1031 exchanges, it is necessary to have a financial professional familiar with real estate by your side. A lawyer is commonly recommended as well. But depending on the circumstance, the complexities could be worth the tax savings you could receive.