The Internal Revenue Code allows investors to defer capital gain taxes when disposing of investment properties with the intent to reinvest the equity into replacement property. What this may allow you to do is leverage the taxes deferred into growing your real estate investment portfolio.

Following strict guidelines and forms (see links below), investors will exchange real estate for the following reasons:

Acquire property using the equity of a previously owned property for a down payment
Defer taxes that would otherwise be paid in a sale
Diversify or consolidate a portfolio
Create a more favorable financing situation
Increase basis and possibly qualify for more depreciation
Geographic reasons
Relief from management

Example
You own an investment property. You bought it for $100,000. You’ve made no improvements. You’ve taken depreciation of $28,992.

It is now worth $190,000. To sell it, the disposition cost in this case will be about 8% (commissions, title and exchange fees, etc.).

Adjusted Basis
$100,000 Original Cost
+ $0 Improvements
- $28,992 Depreciation
$81,008 Adjusted Basis

Realized Gain
$190,000 Sales Price
- $15,200 Disposition Costs (8%)
- $81,008 Adjusted Basis
$103,792 Realized Gain

At this point if you decided not to buy another “like-kind” property, you would likely pay taxes on the realized gain.

However, you decide to buy another “like-kind” property (exchange for another property). The realized gain becomes an unrecognized gain. Proceeds from your sold property are placed in a “qualified escrow account”. Within 45 days of the close date of your previous property, you “identify” a property that meets your investment needs. You “acquire” it for $300,000 within 180 days of the close date of your previous property. Acquisition costs will be approximately $6,000 (title, loan, exchange fees, etc.).

Basis after the Exchange
$300,000 Sales Price
- $103,792 Unrecognized Gain
+ $6,000 Acquisition Costs
$202,208 Basis after the Exchange

You have just “exchanged” your existing property for a higher value property using your own equity and deferred capital gains taxes (unrecognized gain) as part of your down payment.

To complete an IRC 1031 exchange, there are rules and timelines that must be strictly followed. Consult with legal and tax advisors regarding your specific situation.

Additional Info on 1031 exchanges
Federation of Exchange Accomodators (www.1031.org)
Investment Property Exchange Services, Inc. (www.ipx1031.com)

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