One of the largest expenses real estate investors incur when they sell their properties is the capital gains tax. This is a tax on any profit you made from the sale price of the property minus the purchase price of the property, also known as your “basis” in the property.
Many other factors go into determining your basis. For example any long-term maintenance you did or permanent additions or other structures you made to the property. Regardless, the end result is a tax of some amount when you sell. However, while this tax cannot be totally avoided, it can be deferred almost indefinitely using a vehicle from the IRS known as a 1031Exchange.
What is a 1031 Exchange?
In a real estate transaction, the property owner is taxed on any capital gain realized from the sale. However, using a Section 1031 Exchange, the tax on the gain is deferred until some future date. Section 1031 of the Internal Revenue Code provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.” A 1031 tax-deferred exchange allows a property owner to trade one or more of their recently sold properties for one or more replacement properties of “like-kind”. The capital gains tax on the sale of these properties is deferred until either the seller liquidates his investments or dies.
The legal reasoning behind the Section 1031 exchange deferment is when a property owner has reinvested the sale proceeds of one property into another, the economic gain of the seller has not been realized in a way that gives the seller actual money to pay a tax. So the taxpayer’s overall investment is the same, it has just changed form. The seller has not at this time received any cash benefit from the sale. The IRS determined it would not be fair to tax the investor on just a paper gain so they created the 1031 exchange.
What are the requirements for a 1031 Exchange?
- Proper Purpose – Both the sold property and the newly purchased property must be held for productive use in a trade or business or for investment. Property bought for immediate resale such as a flip doesn’t qualify for this tax exemption.
- Like Kind – The replacement property acquired in an exchange must be “like-kind” to the property being relinquished. As an example, all qualifying real property located in the United States is like-kind to all other property located in the United States. Property located outside the United States would not be considered like-kind to property located in the United States. However you can do a 1031 Exchange for property outside the United States to another property that is also outside the United States.
- Exchange Requirement – The relinquished property must be exchanged for other property, and cannot be liquidated and then the cash used to buy the new property. This means the 1031 Exchange requires an intermediary to facilitate the transaction.
Who is involved in a 1031 Exchange?
- Investor/Taxpayer/Exchanger As the person selling your property, you can be referred to by any of these names.
- Buyer. The person buying your property. This person pays money to the intermediary and then receives the deed.
- Intermediary. This is any qualified neutral third party not related to the transaction such as a title company or attorney. The intermediary ensures that all of the regulations are followed and places the funds in an escrow account until the exchange is completed.
- Seller. The person selling their property to you. This might not be the same person who is purchasing your property in the exchange. In other words you can sell your property to one party and buy a property from a different party and still qualify for a 1031 Exchange.
What are the specific timing rules for an exchange?
The investor has a maximum of 180 days from the closing of the relinquished property or the due date of that year’s tax return, whichever occurs first, to acquire the replacement property. This is called the Acquisition Period. The first 45 days of that period is called the Identification Period. During the 45 days, the investor must identify the property that will be used for replacement. This identification must be in writing, signed by the investor, and received by the intermediary within the time period allotted. If this does not occur then the 1031 Exchange will be considered null and void and all capital gains owed on the sale will be immediately due…
So long as you keep rolling over your investments into new, like-kind properties, you can defer the capital gains taxes owed indefinitely and still reap the benefits from your new properties.