There are many advantages to a 1031 exchange, whether you are an individual with one rental house or a corporation with a shopping center. The primary advantage is that you may dispose of property without incurring any immediate tax liability from the sale of the property. You then use these tax-deferred proceeds to re-invest in another project. That keeps the money you would have paid in taxes working for you.
Suppose you are the owner of raw land that produces no income and you exchange it for income producing property. Your advantage is cash flow. Suppose you have held this land after the appreciation has peaked. You can start rebuilding equity by exchanging it for new property.
A commercial property might be exchanged for industrial and apartments, giving you diversification.
Exchanging multiple rentals for a single user commercial property can provide management relief.
You could trade up to a better neighborhood or for something closer to home.
Under current federal law, at your death, your heirs get a stepped up basis on the inherited property. Their basis is the fair market value of the inherited property at the time of your death or six months later, whichever they choose.
You must reinvest all the proceeds from the sale of your property and purchase the new property of equal or greater value to avoid paying any capital gains taxes. You must also replace any existing debt with an equal or greater amount of debt.
Any proceeds not reinvested in the replacement property and/or any debt relief is considered “boot” and will be taxed.
Following are two simplified examples (ignoring the effects of depreciation) that illustrate these rules.
|Sale Price||$450,000||Purchase Price||$600,000|
|minus debt||-$200,000||New Debt||-$410,000||0|
|minus Cost of Sale||-$30,000||Closing Cost||$30,000|
|Exchange Proceeds||$220,000||Exchange Proceeds||$220,000||0|
Since the seller acquired $210,000 more debt and reinvested all the net equity, the exchange is fully tax deferred. The tax that he would have paid on a straight sale of this property can go towards the purchase price of his replacement property in a 1031 Exchange.
|Sale Price||$450,000||Purchase Price||$360,000|
|minus debt||-$200,000||New Debt||$160,000||$40,000|
|minus Cost of Sale||-$30,000||Closing Cost||$10,000|
|Exchange Proceeds||$220,000||Exchange Proceeds||$210,000||$10,000|
Since the seller acquired property with only $160,000 of debt, there is $40,000 of mortgage boot. Also, he did not reinvest $10,000 of the net equity, which resulted in $10,000 of cash boot. The combined amounts of $10,000 and $40,000 equal $50,000, which is taxable boot.
It is important to understand that a Section 1031 exchange is just that, an exchange of one property for another. It is not a sale and re-investment, a transaction that will result in taxable capital gains.
NOTE: The content of this website is informational only. It does not constitute tax, legal or accounting advice. Each situation is different and you are advised to seek appropriate professional advice to see if a 1031 Exchange meets your needs.