What is a Tax Deferred Exchange?

They say that nothing is certain but death and taxes, but for the savvy investor, there is a way to take at least some of the certainty out of taxes. This occurs through a tax deferred exchange, sometimes called a 1031 exchange.

The rules for a tax deferred exchange are outlined in Section 1031 of the United States Internal Revenue Code, which provides a way for the transfer of some types of property to take place without the original seller having to pay taxes on capital gains realized from the sale. If the seller purchases another property of a similar type within a certain period, usually a maximum of 180 days, taxes on the net proceeds are “deferred”, meaning the seller does not have to pay them at that time. This is the case as long as the replacement property is being acquired for business or investment purposes.

The tax deferred exchange is most commonly used for the purchase and sale of real estate investment properties, although it is not limited to real estate property. There is also no legal limit to the number of times a tax deferred exchange can be used, making this one of the more powerful ways for real estate investors to build wealth.

Prior to 1984, the rules governing tax deferred exchanges were much stricter than they are today. The sale of the first property and the purchase of the second had to take place nearly simultaneously. In addition, the properties to be used in the exchange had to be of “like kind,” which meant they had to be very similar. If the property being sold was a strip mall with 10 units, for example, then the property being bought had to also be a strip mall with 10 units.

Since 1984, the guidelines have been relaxed so that a “like kind” property can mean real estate of any type- land, office space, apartments, single family homes, etc. The restrictions are that the property must be located in the United States, and that the property purchased by the investor must have a value of between 95% and 200% of the selling price of the property the investor sells as part of the exchange. The replacement property must also be identified within 45 days of the sale of the first property, or the tax deferred exchange cannot take place.