Over the long term, acquiring real estate through exchanges is an excellent method of building wealth.  Section 1031 allows continued deferral of taxes on subsequent exchanges, which enables the owners to increase equity without the burden of capital gain taxes.

Basically, the 1031 exchange is the sale of one property followed by the purchase of another.  It is critical that funds are held by a "Qualified Intermediary," that both properties are of "like-kind," and the exchange time period requirements are met.

Contrary to what most property owners envision, a 1031 exchange is rarely a simultaneous two party swap.  In phase one the exchanger sells the property.  This is when the exchange period begins.  The exchanger has 180 days from the Phase I closing date to acquire the replacement property and must identify the replacement property(ies) within the first 45 days. 

Phase II is the acquisition of the "like-kind" replacement property, which can be closed at any time during the 180 day exchange period.

Example

To understand the powerful protection an exchange offers, consider the following example:

• An investor has a $200,000 capital gain and incurs a tax liability of approximately $70,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold. Only $130,000 remains to reinvest in another property.
• Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property.
• If the same investor chose to exchange, however, he or she would be able to reinvest the entire $200,000 of equity in the purchase of $800,000 in real estate, assuming the same down payment and loan-to-value ratios.

POTENTIAL "LIKE-KIND" PROPERTY EXCHANGES AND BENEFITS: