How a 1031 Exchange Works

A section 1031 tax deferral allows an investor to sell a property, then reinvest the proceeds in a new property and defer all capital gain taxes. Specific conditions for the exchange state that it must be of “like-kind” and must take place within 45 days of the close of the sale. To understand more about how this exchange works, consider the following example:

•If an investor has a $200,000 capital gain and incurs a tax liability of $70,000 in combined taxes when the property is sold, only $130,000 remains to reinvest in another property.
•If the investor had, for example, a down payment of 25% and a loan-to-value ratio of 75%, the seller would only be able to purchase a $520,000 property.
•If the same investor chose a 1031 exchange, however, and had the same down payment and loan-to-value ratio as above, the entire $200,000 of equity could be reinvested in an $800,000 purchase of real estate.

The exchange offers a powerful protection for investors from capital gain taxes. However, knowledge of what qualifies for a 1031 exchange, and how it works is crucial to receive the full benefits that it can offer. For example, not all real estate qualifies for the exchange. Business property and investment property are the only types that will qualify for the tax deferral.
Both the property sold and received must be of “like-kind”, which is often mistaken to mean the exact types of properties. The like kind provision for real property is quite broad, and includes land, rental, and business property. A 1031 exchange may actually be mixed as to type and still be like-kind. For example, you may exchange land for a duplex, or a commercial building for a retail store. The like-kind provision for personal property is more restrictive.
One difficult aspect of making a 1031 exchange is finding a new investment property within the 45 day limit. The IRS is very strict about complying with the restriction and rarely allows extensions. Once a replacement property has been found, the next challenge comes in obtaining the extra capital needed to complete the exchange.
Fortunately, there is an easy way to overcome that challenge. Obtaining a bridge loan is an easy and effective way for a commercial borrower to finance a property for a short period of time. Bridge loans are usually offered for terms of 12-36 months, just the amount of time that a property owner would need for a 1031 exchange.

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