If you want to invest in real estate for cash flow, it’s best to have the 1031 tax exchange explained to you in some form.  I love real estate investing and have opted to learn so much about it because of the immense wealth it can create.  The main reason it offers such wealth is because it involves several major tax advantages. 

I have written about how to pay zero taxes on your rental income and other tax deductions you can claim on that rental income.  However, the 1031 exchange is the major tax benefit that will save you a bunch of money over time and, thus, help you build your real estate wealth quickly.

[Disclaimer: The following is not intended as legal advice.  Consult your own attorney to confirm that you can benefit from a 1031 exchange.]

What Is The 1031 Tax Exchange?

The 1031 tax-deferred exchange is a way for a real estate investor to defer taxes on capital gains (which can range from 20% to 30% depending on the laws that apply) by “exchanging” one property for another property. 

Where Can I Find This Rule?

The 1031 Exchange is stated in section 1031 of the IRS Code of 1986.

What Do You Mean “Defer” Taxes?

By “defer,” a 1031 Exchange allows you to–literally–defer or put off paying taxes on the gains in value of your investment property.  In other words, if you own your property for 3 years, and it gains $50,000 in value during that time, you can defer paying taxes on that $50,000 capital gain. 

You Mean I Won’t Have To Pay Taxes On That $50,000 Gain??

No.  You get to defer paying taxes.  It’s not an outright exemption from paying.  You simply can put off paying them. 

Until When Can I Defer Or Put Off Paying Those Taxes?

Until . . . forever.

What??  Forever??

Well, theoretically.  Yes.  Forever.  You can put off paying taxes on the value your properties gain during your lifetime.

What About After My Lifetime?

Well, that’s the subject of another post.  But this post is about you and your money.  The 1031 Exchange allows you NOT to have to pay taxes on capital gains on rental properties that you own and, instead, to defer paying those taxes until some future date. 

How Does The 1031 Exchange Work?

Very simple.  You sell one property, and then you acquire another property within a specific period of time.  It’s basically the same as selling one property and buying another, except that, for purposes of the tax code, this transaction is treated as an exchange and not a sale. 

If you sell your personal residence, you have to pay taxes on any capital gains on the property (unless certain exceptions apply).  But, as an investor, you can “exchange” one property for another and defer taxes.

5 Requirements Of The 1031 Exchange

To benefit from a 1031 exchange, you MUST follow the following 5 basic requirements when you sell and buy–or “exchange”–your properties:

1) The purchase price of the property you buy (the replacement property) must be equal to, or greater than, the sales price of the property you sell.  The replacement property must be, in tax law terms, a “like kind” property. 

Thus, you can’t buy two lesser properties or one lesser-valued property.  The property you buy must be worth equal to or more than the one you sell.  You’re effectively trading up.

2) All the equity you receive from the sale of the first property must be used to buy the replacement property. 

So, if you have $100,000 in equity (the total of the down payment, principal payments, and appreciation) in the property you want to sell, you must apply the entire $100,000 to the purchase price of the property you buy.

3) The proceeds from the sale of the first property must go through the hands of a “qualified intermediary.”  In other words, you can’t touch the money from the sale, and neither can your agent or broker.  There are individuals and companies who perform this “qualified intermediary” service for you.  

4) Within 45 days of selling the first property, you must identify other replacement properties that you wish to buy.

5) You must buy the replacement property within 180 days of selling the first property.

The real estate investor has to follow each of these requirements exactly as stated or risk Uncle Sam taking a bite out of your capital gains. 

Why the 1031 Exchange?

It encourages investors to provide rental housing to people who can’t afford to buy or don’t want to buy.  It’s a brilliant incentive system for helping renters save money and encouraging investors to make money. 

The investor can continue “exchanging” for and trading up to acquire larger properties and increasing his or her rental income.  You go through this process much quicker by retaining the taxes you’d normally have to pay on capital gains.  Instead, you can apply that money to your subsequent purchases to increase your investment and, in turn, your income.

It’s amazing how much money you can make when you don’t have to pay taxes.       

And that is the 1031 tax exchange explained.  I hope this helps!

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