The 1031 exchange is a simple technique used by investors to defer capital gains tax that you can use too. When the 16th Amendment was ratified in 1913, it allowed Congress to levy an income tax. However, it was not until 1918 that Congress passed the first income tax. This opened the door for a capital gains tax.

There were some problems though. People would buy property A, sell it 5 years later, and buy property B using the money from property A. As real estate is wont to do, property A went up in price and the investor made a “profit.” The IRS would have taxed the investor for the profit, even though the money was used to buy property B and the investor NEVER realized a profit!

There were certain fixes/loopholes to this but it wasn’t until 1954 that Section 1031 was added to the Internal Revenue Code. Section 1031 outlines the tax-deferment of like-kind property being “exchanged.” When section 1031 was first implemented, the exchange was between 2 people who each owned a property. There would have either been a “swap” between two people, or one of the two would have sold (cashed-out) and been obligated to pay capital gains tax on his or her capital gains.

It was not until the famous Starker v United States case in the 1970s that you could have a 3-person exchange. Starker allowed for an investor to sell Property A and use the proceeds to buy Property B without paying tax on the capital gains from selling Property A without merely “swapping.” A “Starker exchange” is one in which Property B is identified within 45 calendar days and purchase Property B within 180 calendar days.

So, what does this all mean to you? This means that you can buy investment property and a number of years later sell it, then use the proceeds to buy a bigger/better investment property without paying capital gains tax on the sale of your first property. This DOES NOT mean that you won’t pay taxes on your gains, it just means that you are deferring your payments into the future.

There is nothing wrong with using 1031 exchanges indefinitely and deferring your tax for as long as you can. From a tax-planning standpoint, it is possible to put your investment property in a charitable trust, which could pass on to your beneficiaries tax-free.

You can choose more than 1 replacement property provided you meet one of the following three requirements:

1. Any THREE properties regardless of value
2. Any number of prospective replacement properties provided the Fair Market Value (FMV) of the replacement properties is at least 95% of the FMV of property A.
3. Any number of prospective replacement properties provided the total value of all the prospective properties does not exceed 200% of the (FMV) of property A.

There are some additional rules regarding the 1031 exchange, which should also be discussed.

• If Property B is less than the price of Property A, you will receive some cash. This cash is known as “boot” and you WILL be liable for this boot as capital gains income.
• Property A & B must be “like-kind.” This means that you cannot use a 1031 exchange between a primary residence and a commercial property.
• Proceeds from the sale of Property A to pay for non-qualified expenses (such as service costs) are NOT tax-deferred. It is always advisable for the buyer to bring cash to the closing to pay for non-qualified expenses.
• Any money borrowed to pay for Property B will be applied to the price first. This means that any gains from Property A will be recognized as income for tax purposes.

1031 exchanges are one of the best vehicles used by investors to defer their capital gains. However, if property B is LESS THAN property A, it is NOT advisable to do a 1031 exchange. This will defer your capital loss forward and you will be unable to deduct the loss on your tax return!