What is a 1031 exchange?

Postponing the tax

When you sell an investment property at a profit, you normally owe capital gains tax. A 1031 exchange lets you postpone that tax by putting the proceeds into another investment property instead.

The rule comes from Section 1031 of the Internal Revenue Code. It says no gain or loss is recognized when you exchange property held for business or investment use for property of like kind, provided the new property is also held for business or investment.

The tax is deferred, not forgiven. But deferring it means your full sale proceeds go to work in the next property rather than a share going to the IRS first.

Deferring capital gains

By exchanging into like-kind real estate, you may defer the tax and keep more capital invested.

Like-kind covers business and investment property. Property held solely for personal use, such as a primary residence, generally does not qualify.

Matching equity and debt in a 1031 exchange

To fully defer taxes in a 1031 exchange, you must reinvest an equal or greater amount of equity and replace the debt associated with the relinquished property. However, the debt does not have to be replaced with debt. If the replacement property has less debt, you can make up the difference by investing additional equity.

For example: If you sell a property for $1,000,000 with $500,000 of debt and $500,000 of equity, and your replacement property has $400,000 of debt, you can invest an additional $100,000 of equity to make up for the reduction in debt. Your replacement property would then have $400,000 of debt and $600,000 of equity, for a total value of $1,000,000.

DSTs can provide additional flexibility because you can invest in one or multiple DSTs with different levels of debt, allowing you to structure your replacement investments around the equity and debt requirements of your relinquished property.