Avoid Capital Gains Tax with a 1031 Exchange

Do you own investment or commercial property where the value has significantly increased? If you sell the property, you might owe a sizable amount in capital gain taxes. Consider a Section 1031 exchange, sometimes referred to as a like-kind exchange, where you trade qualified properties while paying little to no current tax as a possible solution.

Despite recent legislation restricting Sec. 1031 exchanges, you can still utilize this strategy for certain real estate transactions. However, keep in mind that a change to the rules has been proposed. So, if you’re considering an exchange, you might want to move quickly.

1031 Exchanges Limited to Real Estate

If certain conditions are met, you may be able to postpone tax on the exchange of like-kind real estate properties under Internal Revenue Code Section 1031. Previously, a variety of property types, including trade-ins of business vehicles, qualified for this tax break. However, as of 2018, only real estate transactions are covered by the 1031 exchange rules due to the Tax Cuts and Jobs Act.

It’s important to know that both the properties you give up and the ones you receive must be commercial or investment properties. Personal residence exchanges cannot be used to avoid current taxes, but you might be able to do so for a vacation home that is classified as a rental property. Be sure to consult your tax expert because there could be further issues.

Normally, capital gains tax would be due when selling real estate that had increased in value. If an individual has owned a property for more than a year, the maximum tax rate is 20%. If not, the gain for individuals is taxed at the current top rate of 37% on ordinary income.

There is no current tax owed on the exchange if you satisfy the conditions of Section 1031, with the exception of the amount of “boot” you receive as part of the trade. Boot consists of the money required to “balance things out” or other value concessions (such as a reduction of mortgage debt). Cash and a valuable benefit may occasionally be combined in transactions.

If you receive boot, you must pay current tax on the amount that is equal to the lesser of the realized gain, which is the difference between the adjusted basis of the property being given up and the fair market value of the exchanged property (including any boot), or the fair market value of the boot.

What are the requirements for a 1031 exchange?

“Like-kind” in this context refers to the characteristics or nature of the property. What exactly qualifies as like-kind properties is interpreted broadly by current tax legislation. For instance, you may swap out a strip mall for an apartment complex, upgraded real estate for undeveloped property, or a marina for a golf course. It is not necessary for it to be the same kind of property (for example, a warehouse for a warehouse).

Timing is crucial. For a 1031 exchange to be eligible for tax-free treatment, the following two deadlines must be met:
1. The title for the replacement property must be transferred to you no later than 180 days after the legal ownership of the relinquished property is transferred, or by the earlier of your tax return due date, plus extensions, for the tax year of the transfer.
2. You must identify (or actually receive) the replacement property no later than 45 days after the legal ownership of the relinquished property is transferred.

On the day that legal ownership of the property is transferred, the 180-day window officially starts. The deadline for filing tax returns may decrease the period if it spans two tax years. Therefore, the due date for 2022 returns (April 18, 2023) would arrive before the 180-day period if you relinquish ownership of the property in November or December of this year. As the end of the year approaches, keep this in mind.

It’s also unlikely that you’ll own property that someone else wants to buy when they also own property that you want. These one-to-one transactions are uncommon. Real estate trades under the 1031 exchange typically include many parties.

Multi-party transactions

You might complete a 1031 exchange through a “qualified intermediary” depending on your circumstances. The qualified intermediary is essentially a third party that aids in the transaction. In accordance with the terms of their agreement, the qualified intermediary will do the following:

  • Purchase the property being relinquished from the taxpayer;
  • Transfer the property to the buyer;
  • Purchase the replacement property from the seller; and
  • Transfer the replacement property to the taxpayer.

The taxpayer’s ability to receive, pledge, borrow from, or otherwise benefit from cash or other property held by the intermediary must be restricted by the agreement. Furthermore, some IRS reporting standards must be followed. Usually, the intermediary charges fees based on the property values.

Who can assist with a 1031 exchange?

A Sec. 1031 exchange is not something you should do on your own unless you have extensive experience in the area. Engage the help of experts, like one of our CPAs, who can give you the support you need.