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Adriana West (Keller Williams First Atlanta): Real Estate Agent in Roswell, GA
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Just what is a “1031” anyway?

The number 1031 refers to a section of the Internal Revenue code dealing with Capital Gains taxes.  If you are an investor in Real Estate, this will matter to you.  Otherwise, you will find it as interesting as you find any trivia.  1031 allows you to defer paying your capital gains taxes on a current property until you sell a future property.

What it does NOT do:

  • It does not mean you have to pay less taxes – you will pay the full amount of taxes you need to pay at some point – just not as part of selling the current property.
  • Allow you to sell a strip mall to buy your vacation house without paying the tax.

How Does a 1031 Exchange Work?

If you have an investment property, and you sell it at a gain, you are liable to the IRS for taxes on the difference between what you invested (less depreciation) and the amount you received from selling the property.  That difference is called a Capital Gain – the “gain” you received on the “capital” you invested.  Capital Gains are taxed at their own rate determined by law and changed by Congress from time to time.  As of this writing, the Capital Gains rate is 15%.  This means that if you purchased a property for $1M and sold it for $1.1M (ignore depreciation for a moment), you would have made a Capital Gain of $100,000.  The IRS would expect you to pay $15,000 in Capital Gains Tax.  This leaves you with $15,000 less to invest in the next property.

If you follow all the appropriate rules under section 1031 of the Internal Revenue Service code, you would not pay that $15,000 when you sell the property – as long as you purchase another property for the same purpose (also known as Like Kind).  This means “Same Purpose” to you – which is a passive investment property.  You can roll that whole $1.1M into the next property (or set of properties).  However, your invested capital in that new property is not 1,100,000, it is $1,000,000 – the amount you invested in the first property.  So when you sell this second property for $1,250,000, your gain is 250,000 not 150,000.  You can continue to roll this over using section 1031 until you sell the last investment property.  At that time, you pay the capital gains tax rate on the sale of that property minus the original $1,000,000 (again, removing depreciation from the question).  And you pay that capital gains tax at the rate that is current when you sell that last property – which may be higher or lower than now.

What are the rules?

  1. Designate that the sale of the current property is intended to be a 1031 exchange – before the property is sold.
  2. Identify the property you wish to purchase within 45 days.
  • This property must be for the same purpose (to you).  It must be property in which you invest, not a business you operate or a property you occupy.
  1. Close on the second property within 180 days of selling the first (or before the next tax return, whichever is earlier).
  2. Use a “Qualified Intermediary” to ensure all laws were followed properly.
  3. It only applies to the amount used in “like kind” exchange (so any portion you take out as cash or any value you receive out of the sale of the first property that is not cash invested in the second will be taxed).
  4. The second property must carry the same or more debt than the first property had when sold (any difference is taxable).

What is a Qualified Intermediary?

A qualified intermediary is a person or company certified to be able to manage a 1031 exchange according to the IRS rules.  They receive the money from the sale of the first property and arrange for it to pay for the closing of the second property (you never control the proceeds directly).

We recommend the use of Base Company, Inc. as the intermediary for our client’s 1031 exchanges.  They have performed dozens and dozens of these exchanges over the past three decades and are experts in the process.

Is a 1031 exchange always a good thing?

No.  You should consult a tax advisor before committing to a 1031 exchange.  It may not be right for you if:

  • You believe that Capital Gains rates will be significantly higher when you sell your next property. (in financial terms, the Net Present Value of investing the current capital gains tax amount is negative)
  • The investment funds were already tax advantaged (for example, the funds came from a self-directed Roth IRA LLC).