As a common cliché would have put it, taxes are inevitable. However, we break tradition in this article as we discuss a method to avoid paying taxes.

Exchange 1031 is a provision that allows the homeowner to keep the entire proceeds for the sale of a real estate property by exemption of payment of capital gains tax.

A Closer Look at Exchange 1031

This privilege is governed by the provisions of the IRS Code under section 1031, thus the term Exchange 1031. This incentive aims to perk up business activities in the real estate sector by giving due consideration for homeowners who sell their real estate property with the primary purpose of using the sales proceeds to purchase another real estate property.

A graphical demonstration of how significant Exchange 1031 is on the entire buying process would be by looking at the impact of capital gains tax on subsequent buying of ‘like kind’ property.

Capital gains tax levied against the sales proceeds of a real estate property hover in the range of 20% to 30%. This is translated to a diminished buying capacity of the same proportion for a replacement property. In other words, you are left with a net amount corresponding to 70% to 80% of what it was during the sale of the real estate property.

There are pre-conditions that have to be met for the deferment of realized capital gains tax for the sale of a real estate property under Exchange 1031. These include the following prerequisites:

• The fair market value of the replacement ‘like kind’ real estate property should always be equal to, or more than the net sales proceeds of the sold real estate property.

• The entire equity from the sale of relinquished real estate property must be used to pay for the replacement ‘like kind’ real estate property.

The amount of liability for violation will be determined by the violation of any of these two conditions. In the event that the replacement property is bought at a price less than the net equity of the sales proceeds of the relinquished real estate property, an accrued tax liability is incurred by the one who availed a tax deferral under Exchange 1031.

The amount of accrued tax liability is based on the extent of the amount of net equity not utilized for the payment of the replacement ‘like kind’ real estate property.

This only means that exclusion of tax incentives under Exchange 1031 is not absolute when applying the above cited prerequisites. The application of the provisions allow for partial exchange as a result of failure of absolute compliance under the two prerequisites. Exchange under this condition is subjected to partial deferment of capital gains tax liability. Tax liability is applied on that portion of equity that is subject of tax deferral under Exchange 1031 used for ‘non-like kind’ real estate property.

This tax incentive is an essential tool for homeowners and investors to retain in full the equity generated in the sale of a real estate property for as long as it is intended to be used for the purchase of another ‘like kind’ real estate property.