Swap Real Estate to Defer Capital Gains Taxes

Mention a Section 1031 exchange, and many investors in real estate immediately think, "minimize capital gains taxes." But a 1031 exchange may provide other advantages.

1031 Exchange Tax Deferral

In a 1031 exchange, you sell a property held for business or investment purposes and swap it for a new one you purchase for the same purpose, allowing you to defer capital gains tax on the sale. The exchange may also be used to defer another tax—depreciation recapture. When you sell property, the depreciation you've claimed on the property is generally taxed at 25%. Selling the property as part of a 1031 exchange also lets you defer this tax. Since the corporate tax rate tends to exceed the capital gains tax rate, this can further support the benefits of your exchange.

Of course, there are requirements. Proceeds from the sale must be held in escrow by a third party and then used to buy the new property. You can't receive the proceeds, even temporarily. The properties being exchanged must be considered like-kind by the IRS for your capital gains taxes to be deferred. Taxes are due when the property is sold. But if used correctly, there is no limit on how frequently you can exercise 1031 exchanges. So, in theory, the exchange can be used to defer taxes for your lifetime, which leads to another advantage.

An Estate Strategy

The ultimate tax deferral occurs with the investor's death. At that time the investment property receives a step-up in cost basis so your heirs don't inherit the previously deferred tax liabilities.

An Investment Tool

A 1031 exchange can also be used as an investment tool. You might use it to increase your real estate portfolio without investing additional money. The additional equity created by the capital gain in the original property is redeployed instead of you coming up with additional capital for a subsequent purchase. This offers the potential to increase wealth creation over time.

Also, consider exchanging one large real estate investment for several smaller ones. This strategy can broaden your property portfolio by type and location and help you respond to changing real property markets, as your needs may require.

A 1031 exchange could potentially build wealth. However, understanding the complex rules requires even the savviest investor to enlist professional help.