The Common Law

I own an investment property. I keep reading about all these California investors and how they take advantage of "1031 exchanges" to buy property in Texas. What is a 1031 exchange?

With the current buzz surrounding real estate investing, it's smart to get educated on different options that may affect the tax consequences of real estate investment decisions. A 1031 exchange is an option that has been available for decades but has become more well-known in recent years. The phrase "1031" refers to the section of the Internal Revenue Service code that sets out the rules that the exchanger of property must comply with in order to successfully complete the exchange.

The 1031 exchange allows property owners to defer tax consequences related to the sale of real estate as long as all proceeds from the sale are reinvested in "like-kind" property within a specified time period and that other well-established procedures are followed. In short, if someone exchanges investment property solely for investment property of a like-kind, no gain or loss is recognized under Section 1031 of the IRS code. Properties are generally considered of like-kind if they are of the same nature or character, even if they differ in grade or quality.

The primary advantage of a 1031 exchange is the preservation of investment capital by deferring payment of capital-gains taxes. If one sells property (rather than exchanging it), he or she must pay taxes on any recognized gain, which can include capital-gains taxes as well as state taxes (depending on the state). In a 1031 exchange, the same person may be able to use his or her profit to acquire replacement property. 1031 exchanges are often preferred because they allow greater net profits, the purchase of larger or additional investment property and a faster pyramiding of wealth.

This column serves only as a mere introduction to the concept of a 1031 exchange and does not constitute specific tax advice. Like many other tax issues, a 1031 exchange has many requirements and sophisticated nuances. Competent legal and/or accounting counsel is always recommended and should always be engaged when considering whether a 1031 exchange might work in specific circumstances.