Real Estate Series: The § 1031 Exchange - Defer Capital Gains Taxes to Build Wealth

By Scott Hennessy On November 7, 2023
Scott is a CPA & Manager at BSB.

What is a § 1031 Exchange?

Gains on the sale of investment or business-use real estate can be subject to as much as 40% federal and state income taxes! If the owner is selling one property to invest in another property (or properties), Section 1031 can be utilized to indefinitely defer all income tax these gains. There are very strict rules that must be followed to secure these lucrative tax benefits, and § 1031 exchanges are not for everyone nor every deal.

§ 1031 Illustrated

Example: Owner of apartment building with tax basis of $300k is receiving net sale proceeds of $1.5M and looking to invest in a new commercial property for $1.5M. Without § 1031, the sale would trigger approximately $300k in federal and state income taxes.

§ 1031 Exchange Benefits

Under § 1031 the seller rolls over their existing basis into the new property and pays ZERO INCOME TAX until the next property is sold, unless another § 1031 exchange is done, which can be repeated indefinitely!

  • You can have flexibility in the replacement property as long as it’s real estate (e.g., residential to commercial swap)
  • By doing a 1031 exchange and deferring the tax, you have an additional equity available to invest the new property
    • Reduce/avoid need for expensive financing
    • Compound returns on equity
    • Allows for larger investment or additional capital available for improvements

The Rules

  1. Qualified Intermediary - Must use a qualified intermediary at closing to hold proceeds in escrow
  2. 45 Day Rule - Must identify replacement property within 45 days of closing
  3. 180 Day Rule - Must Close on replacement property within 180 days

Why the § 1031 Might Not Be Right For You:

  • You must invest in equal or greater value property to defer all the taxes on sale of relinquished property
  • You only have 45 days to identify replacement property – putting pressure on finding ideal new investment
  • You must invest in real property or certain qualified RE investment entities, you can't invest in stocks or LLCs, etc.​

If you're a business owner in the New York Metro Area and need help making the best decisions for your business, request a consultation with our experienced accountants today. We look forward to providing you service.

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