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Understanding a 1031 Exchange: A Tax-Deferral Strategy

What is a 1031 Exchange?

A 1031 exchange, named after Section 1031 of the U.S. Internal Revenue Code, allows real estate investors to defer capital gains taxes by reinvesting proceeds from a sold property into a similar “like-kind” property. This provision benefits all owners of appreciated real estate by enabling tax-deferred growth, simplified estate planning, and the ability to upgrade to higher-value properties.

How 1031 Exchanges Work

  • Like-Kind Property: Properties must be real property used for business or investment. Primary residences, vacation homes, and interests in real estate funds don’t qualify. The exchanged properties don’t need to be in the same asset class.
  • Qualified Intermediary: Investors must use a qualified intermediary to handle the proceeds, ensuring they never take constructive receipt.
  • Timeline: Investors have 45 days to identify a replacement property and 180 days to close on it after selling the initial property.
  • Matching Value: The replacement property must be of equal or greater value, including any outstanding debt.

Benefits of a 1031 Exchange

  • Tax Deferral: Defers various taxes on the sale of appreciated property, encouraging continuous reinvestment and potential wealth growth.
  • Estate Planning: Unlimited 1031 transactions allow investors to upgrade properties throughout their lives, with beneficiaries receiving a stepped-up cost basis upon the investor’s death.

Delaware Statutory Trusts (DSTs)

DSTs offer a passive ownership structure for 1031 investors, allowing them to enjoy income from a professionally managed asset without the hassles of active management.

Comparing 1031 Exchanges and Qualified Opportunity Zones (QOZ)

QOZ funds, part of the 2017 Tax Cuts and Jobs Act, provide broader tax deferral and elimination options for gains from any source, not just real estate. Investors can choose between 1031 exchanges and QOZ funds based on their specific needs and goals.

Key Rules and Recommendations

Investors should work with experienced advisors and intermediaries to navigate the complexities and maximize benefits from a 1031 exchange. Each investor’s situation is unique, necessitating personalized guidance.

Disclaimer: This summary is for informational purposes only and not intended as investment, tax, legal, or accounting advice. Always consult with a professional advisor.

Reference: O’Shea, M. (2024, June 12). What is a 1031 Exchange? Understanding a Powerful Tax-Deferral Strategy. Origin Investments. 

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