A 1031 exchange offers investors the opportunity to defer their capital gains tax obligations when they sell properties for a profit, under certain conditions. In essence, a 1031 exchange allows real estate owners to swap one investment property for another in order to defer any taxes which come due as the result of selling a property.

Here is how a 1031 property exchange works:

  • The process begins when an owner sells a qualified investment property at a profit
  • By selling the property at a profit, the investor has realized capital gains, and therefore becomes obliged to pay capital gains taxes on the earned money
  • Under the 1031 program, investors can reinvest those profits in other qualified properties

When an investor exchanges or rolls the profits from a commercial real estate sale into another qualified investment property, the capital gains taxes on the initial property transaction are deferred into the new property.

Harvesting Equity 1031 Exchange

How to Harvest Equity through a 1031 Exchange

First, evaluate your current commercial or residential property to identify if you have dead equity – built up equity that could be yielding greater returns though a 1031 exchange (e.g. sell one property for $400K in CA and purchase 3 out of state for $150K each).

Know the 1031 Exchange Rules and Requirements

While the fundamental principles behind a 1031 property exchange are fairly straightforward, investors are subject to certain limitations and requirements. These limitations and requirements must be honored, or the profits from the original sale cannot be shielded from capital gains taxes.

Four major conditions must be met to qualify for a tax-deferred property exchange:

  • Timelines. First, the investor must find and report a new investment property to tax authorities within 45 days. The investor then has an additional 135 days to formally acquire that property. These time requirements are inflexible and must be strictly observed.
  • The “like property” requirement. The new investment property must be similar to the property which was originally sold, in that it must be held for commercial gain. Investors are not permitted to divert real estate investment profits into homes they intend to live in. Similarly, 1031 exchange rules do not permit a homeowner to sell a primary residence and use the profits to purchase an investment property.
  • Debt and equity requirements. In a 1031 tax-deferred exchange, investors must assume equal or greater amounts of debt and equity when they purchase a new property. For example, if an investor sells a property for $750,000, of which $400,000 was debt and $350,000 was equity, the new property must be valued at $750,000 or more, of which $400,000 or more must be debt. All $350,000 worth of equity must be used to purchase the new property to qualify for 100 percent tax deference.
  • No cash proceeds. Investors are not permitted to pocket any cash from the sale of the original property.

Shielding investment real estate profits is a straightforward and popular tax strategy which can be used as many times as necessary, so long as the aforementioned conditions are met. To harvest equity without paying tax on the profits, the investor simply has to funnel that equity into a new property.

Advantages of a 1031 Exchange

A 1031 exchange offers many advantages beyond shielding profits from immediate taxation. They include:

  • Increased monthly cash flow
  • Increased leverage
  • Accumulation of assets and wealth
  • Relief from property management responsibilities through exchanges

When used properly, 1031 exchanges offer investors many benefits. Interested parties are invited to connect with further resources through Meridian Pacific Properties’ network of trustworthy 1031 exchange accommodators.