Publication Date: Wednesday, October
Tricks of the trade?
A 1031 tax-deferred exchange can build wealth without paying
by J. Robert Taylor, J. D.
paying taxes is legal, if you follow the IRS Code. When it comes
to real property, doing a 1031 tax-deferred exchange has become
a standard tool in the real-estate investor's toolbox. Long-term
creation of wealth in real estate can be done without ever paying
any capital gains taxes through utilizing tax-deferred exchange
This section of the code applies to all types of property,
including land, homes, apartments, commercial property and even
leasehold property. Investors are generally motivated to exchange
for at least one of three reasons:
First, they want to change their investment from one type of property to another
type, i.e., sell land and exchange it for income-producing property or sell a
property in Tahoe and trade into one in Hawaii.
Second, they may want to sell a property where there is very little or no loan
and trade for a much more expensive property with more leverage so that over
time there will be greater appreciation.
Third, they may wish to diversify the type of real estate they own, i.e., instead
of just rental houses they may want to trade some of their real-estate portfolio
into office buildings.
All of these goals could be fulfilled by just selling the investment property
and then taking the proceeds after tax and buying the new investment. Unfortunately,
this method may cost you approximately 25 percent in capital-gains taxes on your
net gain in the property.
Gain generally equals the selling price minus your original purchase price minus
whatever depreciation you have deducted. There may also be additional taxes due
on any depreciation you have taken on the property. One upside is that the new
property you purchase will have a new tax basis for depreciation purposes. When
you exchange, the old basis is carried over to the new property and thus you
will be getting fewer tax benefits from depreciation; however the benefit of
paying no capital-gains tax usually outweighs any benefits that may be obtained
Most 1031 exchanges today are done by using the delayed exchange rules, since
closing escrows on two or more properties simultaneously can be difficult to
arrange. However, the law only gives you 45 days from the sale of your property
to identify the property(s) you are going to exchange into and time goes quickly.
It's a good idea to structure the sale of property to give maximum flexibility
so that the purchase property can be identified prior to the close of escrow.
That way if there is some delay there will be time to recover. If you miss the
deadlines, your exchange will be disqualified and you will owe the tax.
Sometimes clients are reluctant to sell their property because they
don't know what to invest in. One solution is to find and purchase
you want before you sell. It is still possible to do a 1031 exchange
in that case by doing a "reverse exchange." In other words
you acquire the property you want to buy through the intermediary
prior to selling
Once your property sells then you do an exchange with the property
you have acquired through the intermediary. To do this you have to
to purchase the
property before you sell the property you own. This is rarely done,
but for certain wealthy or resourceful individuals it is possible.
In most cases, you will need a broker who has had considerable experience in
navigating the exchange process. And, it's a good idea to consult with a knowledgeable
real estate attorney if there are any questions or concerns.
It is also wise to consult with an accountant or financial advisor,
however many accountants and financial advisors do not understand
be prepared to ask lots of questions and make sure the answers
deal directly with the tax advantages and disadvantages of doing
J. Robert Taylor, J. D., a real estate attorney
and broker for more than 20 years, has served as an expert witness
and is on
the judicial arbitration panel for Santa Clara County Superior
Court. Send questions
to Taylor c/o Palo Alto Weekly, P.O. Box 1610, Palo Alto, CA, or
via e-mail at [email protected].