Deferring capital gains tax using a 1031 exchange is like getting
an interest-free loan from the government, giving you more cash to invest
in your next property.
IRS Code 1031 allows investors to defer paying federal and state capital gains tax and depreciation recapture when they sell an investment property and buy another investment property of like kind through an exchange transaction. This allows investors to move from property to property without paying tax on capital gains or depreciation recapture. Used properly, a 1031 exchange can be a powerful wealth-building tool. For more complete information on a 1031 exchange visit OREXCO, a division of Old Republic Title. If you are involved in, or are contemplating, a 1031 exchange, you should consult with an exchange facilitator, and either a CPA, or tax advisor.
‘Like kind’ property, and property which cannot be part of a 1031 exchange
In the class of real estate, ‘like kind’ simply means another investment property—you can exchange an office building for a farm, a single family residence for a trailer park or a condo. Though you generally can’t exchange your residence or vacation home it may be possible to use part of it. An example might be the sale of a farm. If the farmhouse itself was the primary residence, its value could be excluded from the exchange, but the value apportioned to the agricultural land and buildings could be exchanged. Another example is a duplex in which one unit was rented while the other was owner-occupied. Exchanges are limited to property in the U.S. and certain U.S. territories.
How a reverse 1031 exchange affects financing
In a 1031 exchange, you sell one investment property to buy another. In a reverse exchange you buy before you sell. As with any 1031 exchange, to avoid paying capital gains tax, you must use all of the cash you are taking out of the property being sold as the down payment for the new purchase. What makes a reverse exchange difficult is that you aren’t permitted to get a bridge loan on the property you are selling, or obtain additional financing on the property you are buying while waiting for the other property to sell. If you do, you risk losing all of the tax benefits of the exchange. Your options are to use your cash reserves or, if you don’t have the cash, tap the equity in an unrelated investment property or a primary residence.