Thanks to IRC Section 1031, a properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
To understand the powerful protection a 1031 exchange offers, consider the following example:
- Assume an investor has $400,000 in gain and also $400,000 in net proceeds after closing. Assuming an investor with a $400,000 capital gain and incurs a tax liability of approximately $140,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. Only $260,000 in net equity remains to reinvest in another property.
- Assuming a 25% down payment and taking on new financing for the purchase with a 75% loan-to-value ratio, the investor would only be able to purchase a $1,040,000 replacement property.
- If the same investor chose to exchange, however, he or she would be able to reinvest the entire gross equity of $400,000 in the purchase of $1,600,000 replacement property, assuming the same down payment and loan-to-value ratios.
As the above example demonstrates, 1031 exchanges allow investors to defer capital gain taxes as well as facilitate significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the Section 1031 code. For instance, an accurate understanding of the key term like-kind – often mistakenly thought to mean the same exact types of property – can reveal possibilities that might have been dismissed or overlooked.