The “Golden Rule” of Real Estate Investing: Like-Kind Section 1031 Exchanges

Author: Matthew Riley

Matthew Riley is an attorney with Bona Law, primarily focused on antitrust, commercial litigation, and federal administrative law. Prior to joining Bona Law, Mr. Riley’s legal practice emphasized transactional work involving real estate and mergers and acquisitions. Matthew’s professional passion is to educate and to clarify complex areas of the law to help clients achieve their goals. Matthew Riley graduated from the University of Kansas School of Law in 2013 and is licensed to practice law in Illinois. He is in the process of obtaining his admission in California.

 

No one wants to pay taxes, and most, if given the option, would pay less.  The United States Tax Code declares certain events taxable (ex. receiving wages, selling property), and establishes rules to assess how much a taxpayer owes on those events.  In some cases the Tax Code empowers taxpayers to choose which tax rules apply, and thereby, how much tax is owed.  Therefore, knowing the tax rules and how they apply to certain taxable events can result in significant and beneficial tax consequences for you and your business.

Like-Kind Exchanges are governed by Section 1031 of the United States Tax Code, as well as Judicial Opinions, Revenue Regulations, Procedures, and Rulings issued by the IRS. Section 1031 should be known as the real estate investor’s “Golden Rule”.  By “Golden Rule” I mean it is a rule investors can apply to accumulate wealth significantly faster than investors who do not follow the rule.

A Like-Kind Exchange is an investment strategy whereby one property is sold and replaced by the acquisition of another of the same kind.  In such an exchange, any taxes that otherwise would be charged to an investor’s capital gains on the relinquished or sold property, are deferred.  The deferment of these taxes allows the investor to enhance their purchasing power in acquiring a replacement property.  To illustrate the ramifications to an investor choosing to apply the Like-Kind Exchange rules, consider the following (fictional) scenario:

Ronald Lump is an investor who got a “steal-of-a deal”, paying $500,000 for an apartment building in an up-and-coming neighborhood in San Diego. After holding onto the property for a couple years and finding his property greatly appreciated from a neighborhood renovation project, Ronald decides to cash out and purchase a bigger-and-better beach front apartment complex in La Jolla. Ronald finds a buyer who purchases his apartment building for $1,000,000.

Below is a table showing the differences in Ronald Lump’s financial position post-sale when applying and not applying the Like-Kind Exchange rules.

Ronald’s Selling Price	$1,000,000.00
Ronald’s Original Purchase Price	$500,000.00
Total Taxable Gain After Sale	$500,000.00
	When Like-Kind Rules Are Applied	When Like-Kind Rules Are Not Applied
Capital Gains Tax Rate on Taxable Gain	N/A	20%
Tax Due After Sale	$0	$100,000.00
Total Amount Available to Ronald Post–Sale that can be Reinvested Into the Beach Front Apartment Complex	$1,000,000.00	$900,000.00

As you can see, applying the Like-Kind Exchange rules enhance an investor’s financial position or purchasing power to acquire a replacement property.  Ronald Lump, by following and meeting the requirements under Section 1031 will have $100,000.00 more than he otherwise would to reinvest in another like-kind property.  Over time, through structuring multiple property exchanges in this way, the value of an investor’s investment portfolio is better preserved and substantially enhanced.

In later blog posts I will provide a basic understanding of what Section 1031 requires and how you can apply it in your next investment.  I will focus solely on real estate exchanges, though Like-Kind Exchanges can be used in exchanges involving other business or investment assets.  The rules and requirements established in Section 1031 are complex, and if not closely followed by an investor, will disqualify an exchange from tax deferment treatment.  Real estate investors structuring a Like-Kind Exchange are strongly encouraged to obtain an attorney’s assistance in preparing and executing such an exchange. By following this “Golden Rule” of real estate investing, you can work to maximize your investing power now and into the future.