One of the greatest aspects of owning real estate is the benefits of tax deferment when you decide to sell your property. This privilege is called a 1031 Exchange and can be enjoyed by anyone with very little effort.

Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.

This does not mean that you have to trade one property for another. Instead, you can use the capital gains earned from the sale of a revenue generating property to buy another revenue generating property. Let’s take a look at an example to better understand a 1031 Exchange and how you can easily benefit from it.

Sample: Five years ago, Gertrude bought a house for $80,000 and will soon sell it for $250,000. Her real estate broker recommended that she use Exchanges R’ Us as her qualified intermediary in a tax deferred exchange, which therefore allows her to defer taxes on all capital gains ($170,000 in this example).

Gertrude finds another house worth $500,000 that qualifies as her replacement property. All goes well with the exchange process, and Gertrude does not have to pay taxes on her capital gains.
Gertrude can repeat this process multiple times throughout the course of her life. Each of her purchases will progressively increase in value, thereby increasing her overall earnings when she opts out of the 1031 Exchange and collects her profits at a later point in life. The only time when Gertrude gets taxed is when she finally collects all her profits, without further investing. But when this happens, the amount she collects is large and will definitely be worth the wait. As a result, Gertrude will retire with extensive comfort, knowing that she has a substantial nest egg that could potentially be worth millions.

All this sounds simple and highly advantageous, right? Well, it is—but there are a couple easy rules to follow.
First, you must complete the transaction within a designated amount of time, usually 180 days without the possibility of extensions. Second, you are not permitted to touch the money generated by the sale of the first property. The reason for this is that there are companies and/or people who serve as “intermediaries” in exchanges. Their job is to hold the funds from the sale of the first property and then transfer them to the seller of the second property you plan to purchase. Unfortunately, though, a few problems with this system have arisen.

Recently, there have been a number of instances when the intermediaries suddenly “disappeared,” and took with them all funds they were holding. Investors lost substantial amounts of money, sometimes up to millions of dollars worth. But it gets worse.

When some intermediaries hold their client’s money, they do so under their own name (along with their other, personal assets) and not their client’s. If, for whatever reason, the intermediary gets sued, the investor’s money is frozen. And if this freeze period lasts longer than the prescribed amount of time for exchanges, the investor loses his money completely and must therefore pay income tax on all capital gains.

You’re now probably wondering, “Where’s the benefit in that?” Granted, this can be risky, but there’s a simple step you can take to protect your profits from these careless and criminal intermediaries. All you have to do is hold the money in an account that has been reserved for your money only and no one else’s. The account should be separate from other clients’ funds and from the intermediary’s money. It should bear your name on it as well, perhaps something like this: “Exchanges R’ Us, intermediaries for Investors Fred and Wilma.” This account should also have your investor’s tax ID or social security number. Now, regardless of what happens to the intermediary, your money is protected and you run no risk of incurring unexpected losses and/or fees.