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What Is a 1031 Exchange?

December 22, 2014

Typically, when you sell business or investment real property, you’re required to pay capital gains tax on the sale. Taxes are a fact of life, but wouldn’t you prefer to defer paying your taxes if you could? 1031 exchanges allow you to do just that. So what is a 1031 exchange? Also known as a tax-deferred exchange, 1031 exchanges give you permission to postpone paying taxes on the gains from your property sale until some future date. Of course, this loophole doesn’t work in every situation and circumstance. Scroll down to learn a little more about 1031 exchanges.

What Is a 1031 Exchange?

What is a 1031 exchange? 1031 exchanges allow you to postpone paying taxes when you sell business or investment real estate. Their name comes from their place in the United States Internal Revenue Code: Section 1031. To set up a 1031 exchange, you must purchase like-kind property with the proceeds from your property sale. Because you’re reinvesting the money you gained, there hasn’t been a great economic gain of note. Although the property has changed, your financial investment hasn’t, so you aren’t yet required to pay taxes. What if I never sell the replacement property? After your death, the property will be bestowed upon your chosen beneficiary. That person will likely receive a “step-up” in the basis of the property, and if they sell the property soon after your death, they will have virtually no capital gains taxes to pay. In a case like this, you won’t just postpone your taxes—you will avoid them entirely! Why should I use a 1031 exchange? First, there is the obvious answer: the deferral of taxes. When you’re selling property, the taxes can be quite high, so this is a significant benefit. Second, since you won’t be paying any taxes on the sale, you will be able to invest more money in your next investment. Third, if you continually use 1031 exchanges and then pass your investment property on to your beneficiaries after your death, you will eliminate your tax burden entirely. Are there any reasons not to perform a 1031 exchange? Certainly. If you aren’t prepared to follow the IRS’s strict rules and regulations, you could incur penalties and fail to receive the benefits of a 1031 exchange. For example, you must find your replacement property within 45 days and close on that replacement property within 180 days. No extensions! There is also a chance tax rates will increase in the future, which means you could pay higher taxes than you would have if you hadn’t postponed your tax payments. In addition, the replacement property’s tax basis is reduced, so if you sell your replacement property, the deferred gain will be taxed. Finally, losses are not recognized, as they are deferred just like your capital gains taxes are deferred.

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Are you interested in setting up a 1031 exchange? If so, we highly recommend that you work with a seasoned professional to ensure you follow the IRS’s many rules, regulations, and deadlines. If you live in southwest Missouri, contact LifeGen Law Group, Attorneys at Law. We can guide and engage you as legal counsel as you begin the 1031 process. Give us a call at 417-823-9898 or click here to schedule a free consultation. We would be happy to help.