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1031 Exchanges: A simple guide to how they work

Updated: Jul 13, 2023





When it comes to real estate investments, one term you may come across is a "1031 exchange." Sounds complicated, doesn't it? But don't worry; this concept is easier to understand than it may seem at first glance, and it can have huge benefits for your tax situation.


The name "1031 exchange" comes from Section 1031 of the U.S. Internal Revenue Code. It's a provision that allows an investor to "swap" one investment property for another without having to pay taxes on the capital gains (the profit you've made from selling your property). Normally, these gains are taxed, but a 1031 exchange gives you a break.


Let's break this down with an example. Suppose you bought a rental property ten years ago for $200,000. Over the years, thanks to a booming market, the property's value has grown to $400,000. If you sell it outright, you'd have to pay capital gains tax on the $200,000 profit. Depending on your tax bracket, this could mean tens of thousands of dollars owed to Uncle Sam.


But here's where the 1031 exchange comes into play. If you reinvest the proceeds of your sale into another property of equal or greater value, you can defer paying capital gains tax. This means you can use that tax money to help purchase your new property. It’s like getting an interest-free loan from the government.


There are a few important rules to remember for a 1031 exchange to work. Firstly, you must identify potential replacement properties within 45 days of selling your original property. Secondly, you have to close on a new property within 180 days of the initial sale. Lastly, the replacement property must be of the same or greater value.


Now, "defer" means delay, not avoid. When you eventually sell your new property, you'll owe taxes on your original gains plus any additional profit. However, many investors use a 1031 exchange again and again, postponing the tax bill until they sell their final property. In the meantime, they use the money they would have paid in taxes to make more profitable investments.


For those planning to leave their real estate to their heirs, a 1031 exchange is especially beneficial. Upon their death, the property gets a "step-up" in basis, which means it’s valued at the market price at the time of their death, not the original purchase price. This could significantly reduce the capital gains taxes their heirs would owe if they sell the property.


To sum up, a 1031 exchange is a very powerful tool for real estate investors. Personally, I have used this technique on prior deals and will continue to due to its strength to add velocity to building wealth. But like all investment strategies, it's not without its intricacies and potential pitfalls. It's always wise to seek professional advice before making major real estate decisions.


Chad Schieler

Focused Capital

Founder | Principal


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