1031 Exchanges

Since 1921, like-kind exchanges have been an avenue for deferring taxes on capital gains from the sale of property. When you sell an investment property (a rental home for example), you’ll be subject to taxes on the capital gains (net proceeds) from the sale. The idea behind section 1031 of the Internal Revenue Code is for the user to defer the payment of taxes on the gain associated with the sale of investment property.

Often thought to be a tool used only by wealthy investors, this is a valuable and beneficial section of the Internal Revenue Code for all Americans and according to the National Association of Realtors, about 95% of the current participants are individuals, not corporations. Recently, critics of the like-kind exchange section 1031 assumed the deferment of paying these taxes when a property sold was leading to a shortfall in funds owed by individuals or was equivalent to a gain the government should collect on. In 2021 the National Association of Realtors conducted research to discover if these claims could be true and what the impact has been of individuals deferring the payment of taxes when exchanging properties for those of like-kind. The results found that most properties currently traded in like-kind exchanges would not be sold if tax was due and could not be deferred.

The research found that instead, owners would hold the properties yielding little in the investment and resulting in less additional tax revenue than previously assumed. Research also finds that 88 percent of exchanged properties were later disposed of through a taxable sale and the taxes paid are 19-percent higher when a property is exchanged and then later sold versus never having been exchanged. Meaning, the tax collection benefit to the government is actually higher because of the exchange. The regulations and details to completing a tax deferred exchange of like-kind property have strict timelines and steps that must be taken.

When you decide to execute a 1031 exchange, you’ll want to discuss it with your local Realtor right away. If you don’t already have one, your Realtor will put you in touch with a Qualified Intermediary and you’ll be able to begin the process with expert assistance that works in step with your regular tax professional. So, what is a “like-kind” property? According to the IRS, Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality. A house is like a house, an apartment building is like an apartment building, and so on. In the process the taxpayer will be given the option to fully defer the taxes on the capital gains or the recapture of the depreciation.

Some (not all) of the requirements to being able to do this would be:

· Acquiring another property within a set amount of time and the property must be “like-kind” to be held for investment or business purposes.

· The replacement property needs to be at least equal in value to the one sold.

· All of the equity gains from the sale of the property must be invested in the replacement.

There are other intricacies to the process as well, for example, if there was an existing mortgage on the property when it sold, that debt may need to be replaced as well to offset the tax properly. Remember too, with a like-kind exchange, the tax is deferred, not eliminated. When the replacement property is sold, the tax is paid; It can also be paid over time by paying a higher income tax because of forgone depreciation; or when the property is passed to an heir and becomes subject to estate tax. The bottom line is that when you plan to defer your capital gains tax with a 1031 exchange, plan it early, plan it with your local Realtor, use a reputable qualified intermediary, and always include your regular tax professional on your team. You will have a successful completion, save some money on the reinvestment, and take advantage of a valuable American tax benefit. For more information about 1031 Exchanges, contact your local Realtor.