If you own investment property – such as a house, condo, apartment building or commercial property that you rent out – you usually have to pay a capital gains tax on the profits when you sell the property. But you may be able to defer the capital gains tax liability by doing a 1031 exchange, which is a like-kind exchange to another property of equal or greater value. The rules are complicated and the time frame is tight, and it’s easy to make mistakes that could result in a big tax bill or a hasty purchase that might not be a good investment. Here’s what you need to know to make a 1031 exchange work for you and to find an expert who can help with the transaction.
What Is a 1031 Exchange?
If you own business or investment property, then you may be able to benefit from a 1031 exchange. By buying another like-kind property of equal or greater value, you may be able to defer the capital gains tax bill into the future – or avoid capital gains taxes if you die before selling the last property.
You can use a 1031 exchange if you file your taxes as an individual, limited liability company, C corporation, S corporation or other types of entities. “Any taxpayer who owns real property interests and can satisfy the requirements of section 1031 can defer gains or losses,” says Holly Belanger, partner in KPMG’s Washington National Tax practice. “The provision is not limited to particular types of taxpayers.”
The 1031 exchange can be particularly helpful if you want to sell your property now, but you expect your capital gains tax rate to be lower in the future. For example, this may be beneficial if you’re in your peak earnings years now but expect your tax rate to drop after you retire. And if you die before selling the last property, then your heirs could receive a step-up in basis and won’t have to pay federal capital gains taxes on the increase in value during your lifetime. The rules may vary by state.
This Doesn’t Apply If:
A 1031 exchange is for investment and business property, not for your primary residence. Your own home is subject to a different tax break that can be more valuable: If you’ve lived in the house as your primary residence for two out of the past five years before the sale, then you can exclude up to $250,000 in home-sale profits from taxes if you’re single or up to $500,000 if you’re married filing jointly. You don’t have to buy a new house or roll it over to receive the tax exclusion for your primary residence. The $250,000 or $500,000 in profits from selling your primary residence are excluded from taxes – not just deferred. Some people who own a rental home end up moving into it as their primary residence for at least two years before selling so they can benefit from this exclusion instead of doing a 1031 exchange.
What Kind of Property Qualifies for the 1031 Exchange?
To be able to defer all of the capital gains taxes, the value of the new property must be at least as much as the property you’re selling. “The taxpayer must reinvest all of the net sales proceeds in the purchase of one or more like-kind replacement real properties of equal or greater value than the value of the property sold,” says Belanger.
The definition of “like-kind” is broad – the new property must also be real estate used for investment or business purposes, but it doesn’t need to be the same type of building or land. “The purpose of both properties must be exclusively for investment or business use,” says Rob Johnson, the head of wealth management and chief revenue officer at Realized Holdings, a technology-enabled platform that provides investment property wealth management for real estate investors. “There is a great deal of flexibility within this definition. Properties do not need to be of the same type, nor located in the same state. For example, a rental home in California may be exchanged for an industrial building in Virginia; raw land in Michigan may be exchanged for a retail building in Texas.”
Your mortgage balance needs to be at least the same level, too. “If you had a mortgage on the old property, you have to have a mortgage on the new property as well, for the same amount or more,” says Michael Eisenberg, a CPA and financial planner in Encino, California.
“The key is you must roll over the market value of the property or higher and the debt level as well,” says Phillip Mitchell, CPA, president of Kroon & Mitchell in Grand Rapids, Michigan, and a member of the AICPA personal financial planning executive committee. “If those two components aren’t met, there will be a capital gain.” You may still be able to defer part of the capital gain if you buy a new property of lesser value.
What Is the Time Frame for Finding a New Property?
You have a limited amount of time to identify the new property and close on the sale. You have up to 45 days after you sell the first property to identify a few properties that you’re considering purchasing for the exchange. You can generally identify up to three prospects. You have to close on the sale of one of those properties within 180 days of the first sale. “If you don’t fit within that window, you don’t qualify,” says Mitchell.
If you sell the first property quickly and haven’t identified the replacement yet, start searching for one immediately. “When the inventory is tighter, you need to start to look right away,” he says.
Another important rule: You can’t touch the money from the sale of the first property and still qualify for the exchange; you need to work with a qualified intermediary who makes sure the transaction is in compliance with the IRS’ requirements. It’s essential to find a qualified intermediary before you sell the first property.
“If an investor takes control of the sales proceeds, the 1031 exchange is void and they must pay taxes,” says Johnson. The qualified intermediary has three main responsibilities to make sure the 1031 is in compliance with IRS rules: holding the investor’s cash proceeds from the sale of property in escrow as required by the IRS, documenting the investor’s identification of replacement property within the 45-day period and facilitating and documenting the investor’s purchase of replacement property by transferring the investor’s funds to the title company/seller, says Johnson.
The taxpayer’s family, employees, accountants, lawyers, real estate and investment brokers cannot serve as the facilitator, but a CPA or real estate agent can typically recommend a facilitator, says Belanger. Many facilitators belong to the Federation of Exchange Accommodators, she says.
Is a 1031 Exchange Right for You?
A 1031 exchange can be especially helpful if you are in a high tax bracket now and you’d like to defer the taxes on the property sale until later, when you expect to be in a lower tax bracket. For example, if you’re at your peak earning years now, but you expect your income to be lower when you retire in a few years, this might be the right move for you.
The 1031 works best if you die before selling the last property. In that case, you can avoid the capital gains tax bill and the tax basis will be “stepped up” to the value at your death for your heirs, eliminating the capital gains taxes on the growth in value during your lifetime. “That’s the holy grail,” says Mitchell. “For people with more than sufficient savings who will never need the money, this is a great intergenerational planning tool.”
Additionally, it can be a mistake to rush into buying a new property to defer the taxes but possibly end up making a bad investment. “Just because you can defer taxes doesn’t mean it makes the most sense,” says Mitchell. “Make sure you don’t just buy a property to defer the gain, but buy a property that fits one that you want.”
In his area, the real estate market is so tight that people who are selling for big gains may have trouble finding an affordable new property to buy within the tight time frame. “Because of the tight timeline, what kind of risk are you taking?” says Mitchell. “Did you just find something so you could do the exchange? Are you not finding the right thing and the right price and buying something that doesn’t make the most sense?”
Also consider what could happen to capital gains tax rates in the future. “There are times where the 1031 could be very advantageous, but you have to weigh the situation you’re in,” says Eisenberg. “We don’t know what the tax laws will be down the road.”
Capital gains rates are very low now – 0%, 15% or 20%, depending on your income, for assets held longer than a year – and could rise in the future. If you know you’ll need the money from the property sale soon and are in a low capital gains bracket now, you may want to think carefully before doing an exchange vs. paying the taxes now. “If you’re in a lower capital gains rate, it might make sense to take advantage of those low rates. What happens if the capital gains rate changes in the future?” says Mitchell.
What to Do Before Making a 1031 Exchange
With such a tight timeline for the exchange, try to do as much as possible in advance. If you own an investment property, it’s a good idea to meet with a CPA or financial advisor well before you plan to sell your property to find out more about how a 1031 exchange may work for you and what types of properties would qualify. Think about the timing that might work out best tax-wise if you eventually need to sell the property for cash and pay the capital gains tax, such as in a year when your income is low.
“Think about what is your taxable income this year and what do you think it will be down the road. It’s like a game of chess – you’re trying to think a few moves in advance,” says Mitchell. “For people who do plan to sell the property, we should be plotting this out. I tell my clients we need to be doing an income forecast for the next five years and thinking about what would be a good year.”