On a technical level, as every real estate person like Rick Vesole knows, a 1031 Exchange gets its name from a current federal statute, Section 1031 of the federal Internal Revenue Code. This particular piece of legislation, and allowed by the Internal Revenue Service, states that an individual can trade properties if: 1) they are both investment properties; and 2) the replacement property has the same or higher market value. Doing so, Rick Vesole points out, allows the individual using the statutory tax shelter mechanism to avoid capital gains tax as the value involved remains in a property and is not cashed out.
How Capital Gains Taxes Normally Work
When someone sells an investment property, i.e. land or land with a structure on it, he or she has to pay taxes on any increase in value that has occurred since the property was first bought, plus recapture of any depreciation taken. So, as Rick Vesole provides in a simple example, if one bought a home for $100,000 and then sold it years later for $150,000, the $50,000 difference in value gain would be taxable as a capital gains income. And this would normally be the case if one had to sell a property in one location to then buy another property elsewhere.
However, with a 1031 Exchange, a buyer can literally trade one property for another as long as both are for investment and the replacement property has the same or a higher market value. So, as Rick Vesole provides in another example, if one had an investment home in Redding, CA and wanted to trade it for a home in Santa Barbara, as long as the 1031 requirements are met, the buyer could essentially avoid any tax in doing the swap through a 1031 exchange.
The 1031 Defers Tax Versus Eliminating It
Taxes are not avoided altogether, Rick Vesole warns. Instead, the capital gains built up are simply deferred until such time that the person does actually sell the final property in the chain of ownership. All that has happened is that the 1031 Exchange option has allowed the person to move their investment value from one physical property to another of like value at the time of the move.
Back to Rick Vesole’s original example. If the person bought a home in Redding for $100,000, it increased in value to $500,000, he then used a 1031 exchange to swap it for a small little beach home in Santa Barbara for $500,000 and then eventually sold it, the person would be taxed for the difference of $400,000 capital gains. It doesn’t matter that the property is now in Santa Barbara; the capital gains value follows the move and is still eventually due if the related property holding is finally sold by the owner. However, it is possible to avoid the capital gains tax forever, if you own the property the rest of your life.
While the 1031 Exchange might seem simple in explanation, there are many variations, according to Rick Vesole. There are Direct Exchanges where you literally trade one property for another. There are Deferred Exchanges, where you sell one property, and the proceeds are held by a third party intermediary until you find the replacement property. And there are Reverse Exchanges where you buy the new property before you sell the original property. Each of these types of exchanges have their own rules that must be followed in order to avoid taxation.