1031 Exchange vs. Selling: Tax Implications Explained

November 30, 2023
1031 National Services

When a property owner decides to sell, it has two main options: It can conduct a traditional sale, or it can conduct what is known as a “1031 exchange.” While conducting a 1031 exchange isn’t an option in all scenarios, when it is an option, it can provide significant tax savings. As a result, any time you are thinking about selling a piece of property that you’ve held for investment or business purposes, it is important to contact a 1031 exchange company to learn about the options you have available.

1031 Exchange vs. Selling: A Traditional Real Estate Sale

To illustrate the differences between 1031 exchanges and “ordinary” real estate transactions, we can start by looking at a traditional real estate sale:

Let’s say you purchased an investment property for $500,000 in 2015. In today’s market, it is worth $1,000,000, and you’re ready to sell to lock in your gains. To simplify our discussion, we’ll assume you paid cash, so your gain upon selling the property is $500,000—the difference between what you paid and what you received in the sale (ignoring brokerage fees and any other relevant expenses).

With a traditional sale, you would owe tax on this $500,000 in income. Since you held the property for more than a year, this income would be treated as capital gains—which could mean paying a federal tax rate as high as 20 percent. So, all of a sudden, instead of having $1,000,000 to invest, you would only have $900,000. This is a significant delta, and if you add borrowing into the mix, your tax liability triggered by the sale reduces your buying power even further.

1031 Exchange vs. Selling: Acquiring a Replacement Property Through a Like-Kind Exchange

Now, let’s take a look at a similar situation involving a 1031 exchange. Before you sell the property, you engage a 1031 exchange company to help you meet the requirements for a “like-kind exchange” under Section 1031 of the Internal Revenue Code (IRC). You are planning to use the proceeds of the sale to purchase another property shortly after the closing, so Section 1031’s like-kind exchange provisions apply.

In this scenario, rather than the sale triggering $100,000 in immediate capital gains tax liability, this tax liability is deferred. As a result, you have the full $1,000,000 sale price to reinvest. Your purchasing power and borrowing power both increase significantly, and you are able to target a significantly more valuable investment.

To further illustrate the benefits of a 1031 exchange, we can look at a second transaction in the future: 

Let’s go back to the first scenario. After the initial transaction, you purchase a new investment property for $900,000 and eventually sell it for $1,500,000. With a traditional sale, you will face immediate tax liability on your capital gains. Assuming the current 20-percent maximum tax rate still applies (and you don’t have any expenses to deduct), this means you will pay an additional  $120,000 to the IRS—for a total of $220,000 between your two sales. At this point, you have $1,380,000 to invest in your next property.

But what if you did a 1031 exchange instead of a traditional sale? Instead of purchasing another property for $900,000, you were able to purchase a replacement property for $1,000,000. If it is worth $1,600,000 when you sell it and you do another 1031 exchange, you will have $1,600,000 to invest instead of $1,380,000.

That’s a big difference—and the difference keeps getting bigger the longer this process continues.

As you can see, 1031 exchanges can have significant positive tax implications. While these examples oversimplify the process, they illustrate just how beneficial 1031 exchanges can be. As long as you meet the requirements for 1031 exchanges, you can defer your capital gains from sale transactions—and you can potentially do so indefinitely.

To ensure that you meet the requirements for 1031 exchanges—and that you can prove it to the IRS—it is important to work with a reputable 1031 exchange company. Your 1031 exchange company should also be able to serve as a qualified intermediary while you go through the process of acquiring your replacement property (or properties). We provide 1031 exchange services nationwide. If you would like to know more, we invite you to contact us for a free consultation.

Contact 1031 National Services | A Nationwide 1031 Exchange Company

To schedule a free consultation at 1031 National Services, please call 888-872-1031 or contact us online. We will arrange for you to speak with one of our experts as soon as possible.