Should You Swap Your Investment Property? The Basics of Section 1031

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Real estate continues to be one of the most popular investment vehicles in the State of Colorado and throughout the country. This is true despite the well-documented crises experienced in the late 2000s and more recently with the pandemic shutdowns. In all likelihood, the current situation will probably deter a lot of new investors from becoming players in the market; but, on the whole, real estate is still viewed as a viable investment by many, many Coloradoans.

If you’re an investor, one of the most powerful tools you can use is a 1031 exchange. IRC Section 1031 allows owners of investment or business real estate to defer capital taxes whenever they sell their property and acquire another property of “like-kind.” In other words, as long as investors acquire a property that is similar to their original property, they can potentially defer 100% of the taxes they would normally incur.

In this post, we’re going to go over the basic mechanics of these transactions and emphasize the level of financial power which these exchanges can confer.

Mechanics of 1031 Exchanges

Most 1031 exchanges are fairly simple in their mechanics. In a standard “delayed” exchange, an investment property owner sells his or her property, engages an intermediary to hold the proceeds, and then ultimately acquires a replacement property. The whole transaction cannot last longer than 180 days, and most transactions don’t last longer than 120 days. In this type of exchange, an intermediary (referred to as a “qualified intermediary” in 1031 parlance) is necessary because the owner is legally prohibited from receiving or even having access to the sale proceeds. The original language of Section 1031 didn’t lay out the rules for how these transactions were supposed to occur; these rules came about later in response to various things which happened since the development of this provision.

In addition to this rather simple delayed exchange, there are other variations as well. There are so-called “reverse exchanges,” which essentially involve purchasing the replacement property first before selling the original property. There are also improvement exchanges, direct exchanges, and so forth.

The Financial Benefits of Exchanges

We may return and discuss the details of these other variations at some point in the future. But for now, readers should understand the immense benefits which these exchanges can provide. When a property owner conducts an exchange successfully and defers 100% of his or her tax burden, that owner is actually “borrowing” those funds to acquire a new piece of real estate. In other words, the owner is essentially receiving an interest-free loan from the government to acquire a new property. Depending on the size of the tax burden, this can translate into a massive financial advantage.

If a property owner can use borrowed tax money to acquire a more expensive property, and that property yields greater returns, then that owner achieves a superior economic position by way of the exchange. There is no limit on the number of exchanges a person can conduct in his or her lifetime. This means an owner can theoretically compound this benefit repeatedly without any real drawbacks.

Contact the Drake Law Firm for More Information

The bottom line is that investment property owners should at least know that this provision is available to use. If you want to learn more, reach out to the Drake Law Firm today by calling (303) 261-8111.

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