The IRS Code 1031 says that if you make a like-for-like exchange, you don’t have to pay the gains tax at the time of the exchange. This is true as long as you have done everything properly, have not received any boot, nor had net mortgage relief. Let me explain this one of many 1031 exchange benefits.
“Like for like,” in this context, simply means “Investment for investment.” You can’t exchange part of your inventory as a builder for an investment, or part of your parking lot for an investment, and have a 1031 exchange. Investment for investment is the major thing for you to remember. The major benefit of the 1031 is its ability to postpone any gains tax, towards the ultimate goal of avoiding it.
How 1031 Exchange Reduces Taxable Income
“Gain” on property is the sum of everything you get in a sale (or exchange) less your adjusted cost. In any sale or exchange, the primary number you will need is your tax basis.
The tax basis on a property is like book value. When you buy a property, it has a value. You can add to the value by building something on the property. You can take away from it by certain deductions, such as removing part of the improvements, or depreciating the assets over the years as allowed by the IRS.
In the tax law revision of 1986 the depreciation rules were revised drastically to reduce real estate as a major tax shelter for investors. The tax laws also revised the method calculations for adjustment of basis.
In essence, when you depreciate a property you artificially reduce its value, and reduce the Babis accordingly. In reality, of course, depreciation has little effect on actual value. The IRS allows depreciation to be treated as an actual expense (even though no money was spent) and, as such, in the year-end tax accounting it will reduce actual earnings or profits.
As earnings are automatically reduced each year, you pay tax not on actual earnings but the reduced amount. Depreciation, as an allowable expense deducts for income producing and investment property, reduces the taxable income from that investment.
1031 Exchange benefits include allowing you to shelter income because while the taxable income has been reduced, the actual income has not.
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