Tax Mitigation Playbook: What is a 1031 Exchange?

Financial Planning Dentist

1031 exchange is one of the most popular tax strategies available when selling and buying real estate “held for productive use in a trade or business or investment”. It allows the owner of a property to exchange one asset for another. Our clients uses this strategy to:

  1. Scale Up – by increasing the size of their real estate portfolio – by swapping a smaller asset for a larger asset and adding leverage or cash to increase their total investment.
  2. Combine assets – by selling several small properties to own a single large asset.
  3. Relocate – Assets like property are stationary, life is not. If you own a property you cannot easily see you expose yourself to risks you can easily avoid.
  4. Diversify – by selling a single asset to take a stake in a DST or more diversified real estate partnership. 
  5. Scale Down – by selling their rental property and replacing it with a stake in a partnership with lower personal management requirements.
  6. Scale Out – by swapping an asset for a stake in a partnership that will allow them to sell smaller parts at their desired pace

A 1031 exchange, also called a like-kind exchange, abbreviated in some cases as LKE, is the result of a landmark legal decision of T.J. Starker v. U.S., 602 F. 2d 1341 (9th Cir. 1979).

Starker v. U.S. is a significant development of the 1031 tax exchange rules. It was in this case that, the Ninth Circuit Court held that non-simultaneous 1031 exchanges were permissible and set the precedent for the current 180 day non-simultaneous, delayed tax-deferred like-kind exchange transactions. Also referred to as a Starker Exchange.

Starker Trust, or tax-deferred exchange, was first authorized in 1921 when Congress recognized the importance of encouraging reinvestment in business assets.

Today, taxpayers use 1031 exchanges to increase cash flow by deferring taxes on gains realized through the sale of real estate, as long as they reinvest those gains in the replacement property. In practical terms, a taxpayer sells a property used for business or investment to exchange for another property also for use in business or investment. When transacting an exchange, the taxpayer never receives nor controls the funds from the sale of their relinquished property. The funds are directly used to purchase the replacement property.

This is Key:

Because the taxpayer never actually gains the proceeds from the sale, they may defer the tax they would pay if they simply sold a property and kept the money.

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