Real Estate Glossary – 1031 Exchanges Explained
Isn’t real estate all about buying and selling property? Well, yes, that is a large part of what real estate is about. However, there is a bit more to it beyond its most basic definition. Real estate is a complex form of equity venture that comes with many alterations and modifications to the traditional approach. Such differences in approach are clearly visible in the realm of a 1031 exchange.
So what exactly does a 1031 exchange entail?
The number 1031 refers to a section of the internal revenue code that deals with real estate tax issues. Specifically, this code deals with the exchange of property based on the deferred recognition of capital gains or losses when the property is exchanged. This means taxes on capital gains are deferred and not due. For those not familiar with the term capital gains, this is basically the amount of profit you have earned on the home due to increased equity or value. The reason for this is that no money has changed hands as the property has not been sold. Instead, one property has been exchanged for another.
Does this mean that any and all properties fall under the category of a viable 1031 exchange? No, there needs to be certain criteria met in order for the plan to go forward. Specifically, the properties involved in the exchange must be intended for use in trade or business or even as an investment. The latter point of being an investment may allow for the trade of one residential property for another.
It is also necessary that the properties that are exchanged must be “like kind.” In other words, you should be exchanging a business for a business and not a small business for a beachfront mansion. This prevents the traders from pulling a proverbial fast one over the IRS and getting away with beating the capital gains tax laws. In some instance, “like-kind” refers to the exchange of domestic properties. That is, exchanging a home in the United States for one in Canada may not qualify under these laws.
Capital gains taxes can completely constrict investment and commerce. That is why there are so many laws and loopholes present to circumvent paying capital gains taxes. This is why the 1031 exchange was devised as it provides a means of keeping the real estate industry alive even in a world of high capital gains taxes.
If you are not completely familiar with the concept of a 1031 tax exchange, it would probably be best to consult with an accountant or tax attorney that has experience in this realm. This way, you can make sure that the process works effectively for you in your ventures.
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