In this market of tight budgets and shrinking profit margins, minimizing your expenses when selling a property is essential. Upon closing a real estate sale, any unsheltered capital gains will be subject to significant taxation, which can take a bite out of your profits. One way for a real estate investor to avoid this problem is to utilize a 1031 tax deferred exchange. If used properly, this method is capable of deferring the payment of capital gains taxes. Forever.
Section 1031 of the Internal Revenue Code allows an owner of investment property to exchange property and defer paying federal and state capital gain taxes (up to
15% Federal, 25% depreciation recapture and applicable state taxes) if they purchase a “like-kind” property under the rules set by the IRS. This allows investors to use all of the sale proceeds to leverage into more valuable real estate, increase cash flow, diversify into other properties, reduce management or consolidate holdings.
The questions is, what is considered a “like-kind” property? According to the IRS, “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” In short, an investment property must be exchanged for an investment property. Eligible property types include: single-family rentals, multi-families, commercial properties, and raw land. It doesn’t matter if you exchange from one property type to another, as long as both are investment properties.
Upon closing a property sale, a property owner seeking to employ a 1031 exchange has 180 days between the sale of the relinquished property and the closing of the replacement property. However, the potential replacement property (or properties) must be identified within 45 calendar days from closing on the relinquished property. As long as you follow the “like kind” rule and this timetable, the transaction is eligible for capital gains deferment. As long as you do not sell the new property (without doing another 1031 exchange) you will never have to pay any capital gains taxes. And since these taxes can potentially be wiped out upon your death, they can theoretically be completed avoided by both you and your descendants.
*NOTE – These exchanges can be pretty complicated. Unless you really know your stuff, you should probably hire a consultant to arrange your transaction.