Why Is a 1031 Exchange Important?

photo by Amir Zee, Long Beach, CA

Since 1921, U.S. tax law has recognized that the exchange of one investment or business-use property for another of like-kind results in no change in the economic position of the taxpayer, and therefore, should not result in the immediate imposition of income tax. The exchange rules permit the deferral of taxes, so long as the taxpayer satisfies numerous requirements and consummates both a sale and purchase within 180 days. Real estate investors and commercial real estate practitioners place a very high priority on retaining the current like-kind exchange rules.

So why is a 1031 exchange important? It allows real estate investors to defer paying capital gains and potentially build wealth through real estate investing.

Think about it this way. If you buy a piece of real estate for $100,000 and then sell it for $500,000, you are subject to paying capital gains taxes on your $400,000 profit. From that $400,000, you would lose, say, $120,000 to capital gains taxes. With a 1031 exchange, you might be able to use the full $500,000 to purchase one or more new properties and pay no capital gains taxes at the time of sale. The sale’s proceeds fund new investment properties, which in turn may generate cash flow and appreciate.

A primary and second home or a vacation home held strictly for personal use with no rental activity at all does not qualify for the tax deferral benefits of a Section 1031 exchange. While you’ll eventually have to pay taxes when you sell these new properties, you may be able to make your money go further using a 1031 exchange. These exchanges matter because they can help real estate investors create more wealth. Investors may use 1031 exchanges throughout their careers to buy bigger or better properties and potentially reap the rewards.

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