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How to Use a 1031 Tax Deferred Exchange to Get Rich

By Edited Nov 13, 2013 1 1

 

There are many ways you can get rich investing in real estate, and using the IRS and their 1031 Tax-Deferred Exchange tax strategy is one great way. Guess what - the IRS isn't so bad, after all. They want you to get rich with this tax deferral method. Basically, by using the 1031 you will not have to pay taxes on capital gains (they are deferred) on your real estate as you would instead swap out to another like-kind property.

How it Works

Section 1031 Exchanges allow investors to defer the tax on capital gains until some point in the future. Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction, according to the Federation of Exchange Accomodators.

Here are Some Frequently Asked Questions and Answers - according to the Federation of Exchange Accomodators (www.1031.org)

"What are the benefits of exchanging v. selling?

  • A Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties.
  • By deferring the tax, you have more money available to invest in another property. In effect, you receive an interest free loan from the federal government, in the amount you would have paid in taxes.
  • Any gain from depreciation recapture is postponed.
  • You can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.

- What are the different types of exchanges?

  • Simultaneous Exchange: The exchange of the relinquished property for the replacement property occurs at the same time.
  • Delayed Exchange: This is the most common type of exchange. A Delayed Exchange occurs when there is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property. A Delayed Exchange is subject to strict time limits, which are set forth in the Treasury Regulations.
  • Build-to-Suit (Improvement or Construction) Exchange: This technique allows the taxpayer to build on, or make improvements to, the replacement property, using the exchange proceeds.
  • Reverse Exchange: A situation where the replacement property is acquired prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000. These transactions are sometimes referred to as "parking arrangements" and may also be structured in ways which are outside the safe harbor.
  • Personal Property Exchange: Exchanges are not limited to real property. Personal property can also be exchanged for other personal property of like-kind or like-class.

- What are the requirements for a valid exchange?

  • Qualifying Property - Certain types of property are specifically excluded from Section 1031 treatment: property held primarily for sale; inventories; stocks, bonds or notes; other securities or evidences of indebtedness; interests in a partnership; certificates of trusts or beneficial interest; and choses in action. In general, if property is not specifically excluded, it can qualify for tax-deferred treatment.
  • Proper Purpose - Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. The taxpayer's personal residence will not qualify.
  • Like Kind - Replacement property acquired in an exchange must be "like-kind" to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.
  • Exchange Requirement - The relinquished property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property. Most deferred exchanges are facilitated by Qualified Intermediaries, who assist the taxpayer in meeting the requirements of Section 1031.

- What are the general guidelines to follow in order for a taxpayer to defer all the taxable gain?

  • The value of the replacement property must be equal to or greater than the value of the relinquished property.
  • The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
  • The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
  • All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property."

Why You Should Do it

Let's say you are a real estate investor who had bought a multi-family property for $150,000 and will now sell for a gain of $150,000 ($300,000 sell price). Instead of selling and having to immediately pay taxes on that $150,000 gain (long-term is over a year, you'd most likely end up paying anywhere from 15-25 percent), you can use this 1031 to defer the taxes paid until much later on. This allows you to use the gains as a down payment on a new property. The new property will also be a higher valued property - $150,000 can get you a lot for your money. You can perhaps use that money for a down payment on a $700k+ building!

Resources

If you're considering a 1031 it would be wise to consult with your accountant, or you may wish to do the exchange with a 1031 tax exchange qualified intermediary. One company you can check out is Investment Property Exchange Services, Inc. (www.ipx1031.com). This company specializes in the 1031 and has been in business for more than two decades, according to their website. Another site worth checking out is www.expert1031.com which has a ton of useful and free info.

I wish you the best of luck in using a 1031 tax deferred exchange to get rich!


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Comments

Feb 26, 2012 1:07pm
Goldenpig
Great article I have always envied the american's 1031 exchange. There was an election promise a few years back that they were going to introduce it in Canada but, it never came to fruition.

In my opinion the 1031 exchange makes it a lot easier for someone with modest means to build substantial wealth over the long term.
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