As an investor, capital gains tax on your profits could run as high as 30 percent once state and federal taxes are accounted for—that’s money that could be used for future investments, so what can you do to avoid taking a hit? Enter the 1031 tax exchange.
Under this tax rule, sellers of certain types of property can put off capital gains taxes by immediately reinvesting the proceeds into a similar or “like-kind” property; the IRS will consider the transaction as an “exchange” and not a complete sale, thereby relieving it from taxation.
Simply put, sales are taxable; exchanges are not. Strict guidelines apply to the rule and it has to be done right. For example, timing is of the essence with this tactic.
You have 45 days from the date you sell the relinquished property to identify a potential 1031 replacement property—in writing to the mediator—and 180 days to close on a new property. The 45 days and 180 days run concurrently.
Under the law, you cannot not act as your own facilitator. So it’s beneficial to consult with a lawyer or a tax advisor to set up the sale so that the proceeds can be put into an escrow account until you are ready to use them to buy the new property. That can run anywhere from $900 to $2,500. It’s important to note that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction and make all gains immediately taxable.
Clarifying what can be considered “like-kind” can get complicated because the scope is pretty broad, though it’s basically property of the same nature, character or class—quality or grade does not matter in the exchange.
Real property and personal property can both qualify in exchanges; but real property can never be like-kind to personal property. And certain types of properties are excluded from the rule, such as inventory or stock in trade, stocks and bonds and debt. Additionally, the price of the replacement property must be equal to, or greater than the total net sales price of the relinquished property.
There is no limit on the number of times a seller can do a 1031 on a transaction; one can roll over the gains from the investment numerous times, but any profit made must be immediately reinvested into a similar property to avoid the tax.
The 1031 tax exchange has long been a tool for the savvy real estate investor, although in recent years art investors are getting in on the deal. It’s an ideal tool for real estate investors, but if you’re looking to just raise capital—that’s where the 1031 makes its exit.
The moment you cash out on a deal you have to pay the capital gains tax. Remember that the 1031 is a tax deferment; not a tax-free transaction.
It might be wise to try and get in on the deal now, as efforts to overhaul the federal tax code have shifted into high gear this past year, and legislation has been introduced in Congress to repeal the 1031.
Visit irs.gov for more information on the rule and for access to necessary documents.