[NOTE: Drawing on several decades of experience as a real estate attorney, John Pitrelli contributes articles of interest for home buyers and home sellers. To view John’s other posts please click here.]
A 1031 or tax deferred exchange is a method by which a property owner trades one investment property for another property, without having to pay any federal income taxes as a result of the transaction.
To take advantage of 1031 you must own the property for investment or business purposes. Typically residential rental property or commercial property will meet this requirement. The property does not have to be improved (raw land can qualify). However, certain individuals or companies will not qualify if they are considered by IRS to be “dealers”. For example, if you are a builder and own the property strictly for resale, such as a builder’s inventory of new homes, you will be considered a dealer. Also, if you buy property with the intention of reselling it quickly (“flipping” the property) you may likewise be treated as a dealer and ineligible for a 1031 tax deferred exchange. If you own your property as a second home or use it personally for more than two weeks per year, you will be unable to utilize a 1031 exchange for that property.
If you qualify, the advantages derived from exchanging are abundant. By deferring taxes you can put the same money to work for you in productive ways so that your funds are working and growing while you move on to your next investment. In effect, you are getting an interest free loan from the IRS.
Another advantage of exchanging your investment property is to acquire a property that better meets your investment preferences. For example, you may wish to trade an older property that is deteriorating for a newer property that requires less maintenance and upkeep.
Location is always an important factor in real estate ownership. You may want to change the location of your investment property to one that is more suitable to your current needs. If you self-manage your investment properties, a 1031 exchange may give you the freedom to move both your residence and investments to a more desirable area without any tax consequence.
A tax deferred exchange can also be useful to improve your cash flow. You may be able to find a property to trade for that will reduce your monthly carrying costs or increase your monthly income, or both.
If you plan ahead you may be able to avoid the taxes entirely through a series of exchanges and estate planning or retirement strategies. I hope to deal with these strategies in great detail in future articles.
As you can see, a 1031 or tax deferred exchange can help an investor achieve his or her personal goals and be their saving grace.
If you’d like to get a better foundation on 1031, check out the educational video I did in Kathy’s Video Center. You will get more details on how this process works, but don’t worry, it is not spoken in “legalese.” It is an easy to understand and practical explanation, and we give you the fundamentals quickly, so you can get a sense of whether this might work for you. If you own more than one property now, or if you see yourself having an investment, vacation, or retirement property someday, you should be aware of this option. We also have a more detailed 1031 booklet that you can request, and certainly feel free to call (703 803-8600) or email me (firstname.lastname@example.org) with any questions you may have.