How to Keep More Money In Your Pocket After Selling A House using a 1031 Exchange

A 1031 exchange is a way to avoid paying capital gain taxes on the profit realized from selling an investment house or other type of real estate. The 1031 section of the IRS tax code allows this as long as the realized gains are reinvested in another property to equal or higher value. For example, a person may exchange an older house for a new house in a vibrant part of town.

Because the protocol for using a 1031 exchange dictates that both properties must have similar attributes, these types of transactions are also referred to as a “like kind exchange” or a “tax deferred exchange.” Perhaps the latter best describes the investment swap, as the main reason of engaging in a 1031 exchange is to defer capital gains tax. In fact, as long as both properties are of like kind, the IRS doesn’t acknowledge a gain or loss from the transaction – pursuant to Revenue Code Section 1031.

How Does It Work

To engage in a tax deferred exchange, you can choose to exchange a real property or investment for another of “like kind”. Say you own a commercial building that you rent out and the value has appreciated significantly since you acquired it. If you sell it, then you would have to part with a huge chunk of the proceeds as capital gains tax.

If you do a 1031 exchange to acquire a similar piece of real estate you can defer the capital gains tax or “roll it over.” As a result, you’ll be able to invest the full proceeds of the sale into the second, larger investment.

Why Does the Government Allow This?

In the eyes of the government, a 1031 exchange does not constitute a sale, even though the parties involved are often referred to as seller and buyers. This means there’s no realized economic gain in this type of exchange since the profits will be immediately reinvested. Therefore, there are no immediate tax owed since it is considered as unrealized gain. Taxes must eventually be paid if the property acquired via 1031 exchange is subsequently sold.

What Properties Qualifies for a Like Kind Exchange

The property sold and the replacement real estate acquired must both be held for trade, investment or business purposes. You cannot 1031 exchange real estate that is used for personal use, such as your primary residence. Some of the properties that may qualify include: rental unit, ranch, vacant lot or parcel of land, office building, warehouse, motel/hotel, shopping center, resort rental, commercial, industrial or business premises, apartment buildings and similar real estate.

1031 Exchange Benefits

The main benefit of engaging in like-kind exchange is the opportunity to defer payment of capital gains tax. You can sell certain types of properties and avoid paying capital gains taxes on the sale right away. In fact, taxes can be deferred almost indefinitely thanks to this rule. All you have to do is to keep swapping as long as you want, but make sure you follow the rules regarding timing and target property. The only time that you will be required to pay tax is when taking cash out of the investment. Stocks, bonds, notes and inventory don’t qualify.

Timeframe for 1031 Exchange

Since it can be difficult to find someone who is selling an investment you want who also wants what you’ve got, the IRS allows you to place the proceeds from the initial sale with a Qualified Intermediary (QI), who can be an individual or company that essentially plays the role of the middleman. Any funds from the proceeds not under the control of the QI are subject to taxation. The QI will hold the funds from the original sale in escrow until such time the closing on the replacement property occurs.

This is also called delayed exchange and typically requires quick turnaround of the money to avoid being taxed as a regular sale. You must specify your replacement property within 45 days of the initial sale in writing to the QI holding the funds, and make sure you close the sale within 180 days to avoid losing the 1031 tax-deferred status.

The new property acquired must be of equal or greater value than the initial property, or carry the same or greater debt. If the new or target property is of lesser value, then any cash portion of the transaction will be subject to taxation at the appropriate capital gains rate.

For example, if you sell a commercial building for $10 million, but the target replacement property only costs $8 million, then you will be taxed on up to $2 million in capital gains depending on your basis in the original piece of real estate.

Any portion of real property that’s not of like kind will also be taxed. For example, you swap a farm/ranch and livestock for a piece of land of the same value. Since livestock and the land are not like-kind investments, the transaction will be subject to taxation up to the amount of capital gain realized on the value of the livestock.

There are also specific rules regarding tax deferred exchange of real estate between related parties. You must not dispose of property exchanged between related parties until after 2 years. Otherwise, the tax-free status of the transaction will be voided. The IRS revenue code defines a related party as a family member or any entity in which you have more than 50% stake. This means you’re subject to related party rule if you exchange property for another asset owned by a family member, as well as one in which you own a share greater than half.

If you need to sell a house which is not your primary residence, make sure to look into 1031 exchange.