If you own investment or business real estate, you might be interested in how to sell it without paying any taxes. The IRS offers a great way to defer capital gains tax on real estate by doing a 1031 exchange. I’ll give you an overview of who’s eligible for this tax exemption and what type of property qualifies.
What is a 1031 Exchange?
Whenever you sell a business property or investment real estate, you typically have a gain or a loss. A gain is the amount that exceeds the adjusted basis of the property and a loss is the adjusted basis of the property that exceeds the amount you realize. Adjusted basis is your original cost plus certain additions or minus certain deductions. See IRS Publication 551 for more details about how adjusted basis is figured.
Gains from real estate sales are subject to capital gains tax; however, Section 1031 of the tax code allows you to postpone paying tax if you reinvest the proceeds from the sale into a similar, like-kind property. You sell one property and buy a replacement property within a certain period of time.
What is a Like-Kind Property?
Properties are like-kind if they’re similar in character or use—even if they’re not the same quality. Both properties must be used for business or as an investment—neither one can be a personal residence or vacation home.
Section 1031 specifically excludes exchanges of:
- stocks, bonds, or other securities
- debt or notes
- partnership interests
- certificates of trust
Who Qualifies for a 1031 Exchange?
Individuals, corporations, limited liability companies, partnerships, trusts, and any other taxpaying entity can do a 1031 exchange of business or investment property.
What are the Rules for a 1031 Exchange?
There are 3 ways that you can structure a 1031 real estate exchange:
- Simultaneous exchange – is when one property is immediately swapped for another.
- Deferred exchange – is when you sell a property and then buy one or more replacement properties using an exchange facilitator.
- Reverse exchange – is when you buy the replacement property first, using an exchange titleholder, then sell your relinquished property.
A qualified intermediary or exchange facilitator should always be used for deferred or reverse exchanges because you can’t take possession of cash or other proceeds from the sale before an exchange is complete.
You can’t act as your own facilitator, nor can you use a professional who’s worked with you in the previous 2 years. Breaking these rules can make all the gain from the real estate sale taxable.
What are the Time Limits for a 1031 Exchange?
You can also trigger taxes if you don’t meet the IRS’s time limits for completing a 1031 exchange. There are 2 time limits to be aware of:
The identification period: You have 45 days from the date you sell a relinquished property to identify potential replacement properties. This information must be in writing and delivered to either a qualified exchange intermediary or to the sellers of the replacement properties you’re interested in buying.
The exchange period: You must purchase the replacement property and complete a deferred exchange within 180 days after you sell the exchanged property OR by the due date (with extensions) of the income tax return for the year you sold the exchanged property, whichever is earlier. For a reverse exchange, you have 180 days to sell your relinquished property.
Example of a 1031 Exchange
Let’s say I have a rental property near my existing home in Orlando, but I want to relocate to the beach. I don’t want to manage the rental from a distance, so I decide to sell it and exchange it for a rental property near the beach. If my adjusted basis in the rental property is $50,000, and I realize $125,000 from the sale, that would ordinarily result in a $75,000 taxable gain. But if I invest my proceeds of $125,000 into a rental at the beach in a 1031 exchange, I don’t have to pay taxes on the $75,000 gain.
When Do You Pay Tax on a 1031 Exchange?
You can make 1031 exchanges indefinitely, but when the music stops and the replacement property is sold without being part of an exchange, the deferred capital gain must be realized and taxes paid. Remember that gain is deferred, but never forgiven in a 1031 exchange!
You have to pay tax on the original gain plus any additional gain since the purchase of the replacement property. You report a 1031 exchange on IRS Form 8824 and submit it with your tax return for the year in which the exchange was completed. If you’re interested in doing a 1031 exchange, be sure to consult with a tax professional to make sure you follow the rules and don’t end up with a failed exchange.
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