1031 exchange rules: How to avoid capital gains tax when selling property

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This property is in “productive use.”

© Dusan Kostic/stock.adobe.com

A 1031 exchange refers to the section of IRS code that spells out the law and specific requirements regarding “like-kind” transactions. In short, when selling real property that’s held “for productive purposes,” the IRS says that, as long as the investment proceeds are rolled into a similar investment within a specific time frame, “no capital gain or loss shall be recognized.”

In other words, any profits from the sale would not be subject to capital gains taxes.

But to qualify for the tax break, you need to follow specific rules. Interested in a 1031 exchange? Here’s what you need to know.

Although the term ”like kind” is less restrictive than it may sound, there are a couple of key provisions.

The new investment must be real property that is held for productive use in a trade or business or an investment property. In addition, real property held in the United States must be exchanged for property also held in the U.S.

But there’s no requirement that the new property be of the same type. For example, an apartment rental investment can be exchanged for an industrial property, office building, or any other type of property—as long as it meets the “productive use” test.

The second essential requirement of the 1031 exchange provision is a window of time to identify the new property and a second time frame to close the transaction.

The first key date is 45 days. You must designate a specific property that will be used to complete the exchange within 45 days of the original sale’s close.

The second key date: You have a total of 180 days from closing the original sale to closing the subsequent purchase.

Note that the 180-day time frame is not affected by the date the replacement property is selected. To mitigate the risk of a purchase failing to close, you may designate more than one property as a potential replacement. These properties can serve as a backup plan should the desired transaction fail to close.

Additional rules apply to such designations, but that’s where the simple idea of the 1031 exchange gets nuanced and complex. You’ll need help from a pro.

The final significant aspect of the 1031 exchange is that you do not take direct proceeds from the sale before making the related purchase. To help facilitate the exchange, the IRS allows a qualified intermediary (QI) to hold the sales proceeds in escrow until it’s time to pay the closing agent for the purchase.

This is another area where the rules get quite specific. Given the importance of staying within the exchange requirements and the fact that a QI will be holding money for a significant period, the selection of a qualified intermediary is critical.

One of the great benefits of real estate investing is the fact that depreciation reduces your tax burden.

Here’s a short course on real estate depreciation: Each year you get to deduct a portion of your investment (based on its estimated life) from your operating income. For example, if you purchased a property with a building valued at $400,000 (we’ll ignore the land value for simplicity) and a useful life of 27.5 years, you would be able to reduce your operating income by $400,000 / 27.5 = $14,545 each year.

This depreciation reduces the cost basis of the building. If you sold the building five years later for $500,000, your gain would consist of two pieces. The first is a $100,000 capital gain over the purchase price, which is taxed at favorable capital gains rates. The other is the $72,270 above the adjusted basis of $327,275 (that’s the $400,000 purchase less five years’ depreciation: $14,545 x 5 = $72,725).

The IRS will “recapture” the gain provided by the depreciation expense by taxing at the ordinary income rate, which is a higher rate than the capital gains rate. This often comes as a surprise to investors selling a property for the first time.

A 1031 like-kind exchange will defer both the capital gains tax and the depreciation recapture.

There’s no limit on the number of 1031 exchanges you’re allowed to use—you may use the exchange throughout your lifetime. In addition, under current federal estate law, the heirs to a given property would inherit the stepped-up cost basis and thus may avoid capital gains taxes altogether on built-up equity over time. Of course, federal estate law is subject to change, and some states have their own restrictions and limitations. When doing your estate planning, make sure you understand federal and state laws—both in your home state as well as the laws in any state in which you own property.

The 1031 exchange is a tool used by astute real estate investors to take full advantage of all the tax, depreciation, and cash-flow benefits that investment real estate provides. The overall concept is simple, but the execution and nuances of 1031 exchanges can be quite complex. Investors who are new to real estate or the like-kind exchange process should contact qualified tax and real estate professionals to be sure an exchange is executed properly.

And if you do pursue a 1031 exchange, make sure you use a qualified intermediary and pay close attention to the 45-day and 180-day replacement deadlines.