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?
Who is involved in 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.
Excellent article. This is an important strategy for today's investors. We need to maintain all of the value that we can and avoid taxation whenever possible.