Don’t run from the phrase 1031 exchange when it comes up in casual conversation. It’s actually a pretty nifty little tax avoidance tool – consider it a present from the IRS – that real estate investors should take advantage of at every opportunity. Theoretically, you could avoid ever paying capital gains taxes on a property! If that’s not exciting, check your pulse.
Here’s the thumbnail sketch. Usually, when you sell a business asset like a rental property you’re going to pay capital gains tax if it has appreciated in value, and hopefully it has. The 1031 exchange (named after the IRS code where it can be found) allows you to essentially swap one business asset for another, provided they are of “like kind.” Do it correctly and the taxes are postponed.
Nothing sneaky about this. The IRS knows about and encourages the practice. And the cool thing is that “like kind” has, thus far, been interpreted rather liberally. Trade an apartment for raw land, a ranch for a strip mall, or a plethora of other permutations. You can even delay the exchange as long as you designate the replacement property within 45 days of the sale of the first and close within six months.
A word of warning. Follow the time frame rules laid out by the IRS explicitly unless you want to have the transaction nullified and pay the tax bill. A second word of warning. The 1031 exchange rules are not intended for use with personal use residential properties. If you live there, forget about it, except for a few special cases involving vacation homes. The 1031 was intended for business and investment properties. Best to use it for that purpose and not try to sneak one by the tax agents.
A final word of advice. Unless you’re a tax genius, it would be a good idea to contact a real estate attorney with some experience in these matters before proceeding. An error on your part could be quite expensive and ignorance is never an excuse when talking to the IRS.
The Creating Wealth Team
Flickr / Jsome1
