Simply put a 1031 exchange / transaction is when a seller sells an investment property and buys a “like kind” property after the sale. This tactic is used in order to reinvest the sales proceeds and defer paying capital gains
taxes. Keep in mind that at the time when an investor sells an investment property he may be liable for capital gains taxes; this may be due even if the property is sold for a loss.1031 exchanges offer an excellent opportunity to defer the capital gains tax and re-invest and possibly grow your investment after the sale of an investment.Often I have clients come to me as their tax accountant or real estate broker in order to question how it could be possible that they have a tax liability when the investment was sold for less than what they paid. Well, the answer to this question lies in the previous year’s tax returns in reference to this investment. We often forget that investment properties are eligible to take a depreciation loss throughout the life of the investment. For example a residential income property would take depreciation over 27.5 years (other types of properties have different time depreciation life); with that said the cost of the acquisition plus any related services for the acquisition and any improvements to the property would be added up and divided by 27.5 years thereby producing the annual depreciation which an investor may take as a deduction along with any other deductions for maintaining the property in order to offset income from the rental activity. Therefore since depreciation is taken or able to be taken the taxable income is in turn lowered. However, the other side of the equation is that the basis or cost of the property is also diminishing proportionately. Ultimately at the time of the sale you would have a lower basis (original cost) in the investment to reduce your sale price by and could therefore produce a profit even if the sale is technically for less than the purchase price.
Investors should consult their real estate broker and tax accountant in order to determine the best course of action in their particular case.
Ismael Gonzalez III
Licensed Real Estate Broker
Enrolled Agent, admitted to practice before the IRS