How Do 1031 Deferred Exchanges Work

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It seems that no matter what you do with your money or where you put it, the government wants some part of it.  You can’t even buy a cheap and greasy fast food meal without paying taxes on your plate of poison these days!  And when it comes to property sales, many homeowners and sellers are looking for ways to cut back on that tax liability of theirs, and 1031 deferred exchanges may be the answer or at least part of the answer for many.  These arrangements have become more and more popular in recent years and many are taking advantage of them.  But what exactly are 1031 exchanges, and how do they work?  What are the benefits, and what are the requirements?  Of course you should consult with an attorney to be sure of all the requirements for you, but we can give you a general review in this brief article.

Paying Taxes on Equity

The government typically assumes that if you sell a home that has equity in it, that amount of money that you make over and above any mortgages or liens on the home should be considered as profit.  Typically a seller would then pay taxes on that amount at the end of the year.  However, with 1031 deferred exchanges, you may actually put off paying taxes on this home for some time.  How so?

The IRS Code provides for a deferment of taxes on the disposal of a property if that property is replaced with the reinvestment of the proceeds from the sale into another property of equal or greater value.  The arrangement of 1031 deferred exchanges provides for the idea that there has been no real equity from the sale of the property since it has been traded or exchanged for property of approximately the same value.

Taxes Deferred, Not Excused

It’s important to remember that deferred means that your tax bill is not excused; it is simply deferred or put off.  When the property you’ve purchased as a replacement is sold then the original gain you received along with any additional gain from this sale is then subject to taxation.  Of course, this is assuming that there will be gain from the sale of the second property, but that tax bill will of course eventually become due.

Benefits of 1031 Deferred Exchanges

Why would a property owner investigate such an option?  One of the most obvious benefits of the deferred exchanges is that if you are allowed to defer your tax bill, then you have that money available to you to invest to do what you want with it, rather than making a payment to the government for it.  Also, if you are able to defer you tax bill you can then reallocate your investment in your portfolio without immediately paying taxes on those gains.

Requirements for 1031 Deferred Exchanges

Obviously there are some stringent requirements for a property sale and purchase to qualify for exchanges.  For one, the value of the replacement property must be equal to or greater than the value of the property that has been sold or exchanged, as must the equity in the replacement property.

Also, the debt on the replacement property must be equal to or greater than the debt on the exchanged propertyFeature Articles, and all proceeds from the sale of the relinquished property must be used to acquire the replacement property.  The seller of the property may not receive the proceeds or take receipt of funds for the sale in any way.  The seller also has only 180 days to after the sale of the relinquished property to complete the exchange.

These of course are just some basic requirements for 1031 deferred exchanges.  You should of course consult a property attorney before you agree to such an exchange to be sure that your taxes will in fact be deferred.