1031 Exchanges - Avoid Paying Capital Gains

Every investor should know about the IRS tax code 1031 exchange (1031 is the tax code section if you want to look it up). This part of the tax code allows you to sell one investment property to purchase a higher cost (more profitable) investment without paying capital gains taxes and depreciation recapture taxes. The 1031 exchange can be used in many ways such as selling a property and taking part of the profit out but when most of the profit is rolled over into a new investment you can defer taxes on the amount that is rolled over.

This can be a great way of building a financial legacy for your family. You'll definitely want to seek out the advice of a highly qualified 1031 tax expert but there are ways of combining a 1031 exchange with a trust so that you pass on investment properties to your heirs practically tax free. Your heirs can continue building your investment business without seeing it crippled by high taxes. This is a secret to how the ultra rich keep their wealth.

The 1031 Exchange in Summary

There's no doubt that the 1031 exchange rules are complicated and there are a half dozen or more ways you can improve your investment holdings without paying capital gains or depreciation taxes on sold properties. Here is the basic process.

1. Properties qualifying for an exchange must be for business use or investment (“productive use” as phrased by the IRS).
2. Property must be of like-kind (which is generously interpreted by the IRS).
3. A qualified intermediary is required.
4. The investor cannot have constructive receipt of sale proceeds at any time.
5. The 45-day identification period and 180-day closing requirements must be met.
6. Price of the replacement property must be equal to or greater than the relinquished property.
7. The amount of mortgage on the replacement property must equal or exceed that on the relinquished property.
8. All of the funds from the sale must be reinvested in the replacement property.

Those are the requirements for a fully tax deferred exchange. However, you can pocket a portion of the profit and only pay the taxes on the portion of the profit you take out while still deferring taxes on the portion you roll over into the new investment. Below is the simplified version of the four-part process.

Time Restrictions

Most investors consider the time restrictions the toughest part of a 1031 exchange (especially when commercial real estate is involved). As you see in the process above, there are two strictly enforced time requirements. You must identify a replacement property within 45 day of completing the sale of the property you are exchanging for a better property.

You can identify up to three different properties as possible replacement properties. However, as soon as the replacement properties are identified, the 180 day clock starts ticking to perform your due diligence and close the deal. Missing either one of these time requirements will completely disqualify your 1031 exchange and holidays along with weekend days count.

The other major requirement is that a Qualified Intermediary must be used. This is a person holding a specific license allowing them to make the financial transactions on your behalf. The logic behind this is that you are never allowed to have actual or constructive receipt of the funds from the sale. One other point worth noting is that neither the purchaser of your old property nor the seller of the new investment property needs to directly participate in the 1031 exchange. This all might sound complicated but it's really not once you have an expert guiding you through the process. In the end, your tax savings are enormous because you avoid them in full.

Please leave a comment if this article was helpful or if you have a question.

Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for 10 years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest. With the Pacific Ocean a couple of miles in the opposite direction.