1031-exchange-basicsPronounced Ten Thirty One

Let’s say that you have had a second home, a vacation home for a while now, it is a proven good investment, one that has appreciated considerably and you’d like to dispose of it by sale. Technically there could be some problems with the increase in value that has accrued, if you’ve had it for a while. Which means that any cash that you take out of a sale is going to be taxed as a capital gain. Fortunately, there’s a plan for that, as long as you want to keep the value in further real estate investments.

The 1031 exchange refers to the section of the Federal tax code that covers re-investing your profits from the sale of a second home into another of higher value. Because it is defined in the tax code there is a whole host of rules that go along with it. This is a perk for investment properties only; you can’t use it to move up to a nicer home.

The Name Of The 1031 Exchange Game Is Flexibility

You get to exchange like properties for like, the term “like” is very broad in this context. You could exchange commercial space for residential or even undeveloped land. You can even delay the process so that you get the right property to replace your old one.

The great advantage in using a 1031 exchange is that you don’t have to deal with the capital gains tax that arises from the sale of an investment that has grown substantially in value. It prevents a big tax bill when you file your tax returns for that year. If you end up taking out cash in the exchange then that cash will be taxed as a capital gain, charmingly referred to as “the boot”. This is a key point because the tax deferment comes from not taking out the value that you have gained by investing wisely.

Put The Boot Away Until You Are Done

There is one limitation you must keep in mind when you take advantage of a 1031 exchange. It is a deferment, so that when you do finally break the chain, stop reinvesting in real estate and cash out there will be some sort of tax bill to be paid. But that is a good thing because although the tax bill might seem quite large compared to your original investment it is reduced by the compounding gained on the value not given to the government previously, each time you sell and buy new assets.

If you have a vacation home that earns income or you have cash in a bank account that you want to put into a second home or other investment properties the 1031 exchange is a real sweetener. Deferring the capital gain, even as you trade your way into a real estate empire, is a feature that makes investing in real estate so attractive. In fact, it is a great tool for small investors who wish to be big investors one day.