Use 1031s to Defer Capital Gains and Build Wealth
- A 1031 exchange is a tax break. You can sell a property held for business or investment purposes and swap it for a new one that you purchase for the same purpose, allowing you to defer capital gains tax on the sale.
- The properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred.
- Proceeds from the sale must be held in escrow by a third party, then used to buy the new property; you cannot receive them, even temporarily.
- A 1031 exchange can be great for estate planning because your heirs won’t be expected to pay the tax that you postponed paying.
A 1031 exchange is a swap of one real estate investment property for another that allows capital gains taxes to be deferred. To qualify, most exchanges must merely be of like-kind—an enigmatic phrase that doesn’t mean what you think it means. You can exchange an apartment building for raw land or a ranch for a strip mall. The rules are surprisingly liberal.
You need a qualified intermediary (middleman), who holds the cash after you sell your property and uses it to buy the replacement property for you.
45-Day Rule: Within 45 days of the sale of your property, you must designate the replacement property in writing to the intermediary, specifying the property that you want to acquire.
180-Day Rule: You must close on the new property within 180 days of the sale of the old property.
WARNING: The two time periods run concurrently, which means that you start counting when the sale of your property closes. For example, if you designate a replacement property exactly 45 days later, you’ll have just 135 days left to close on it.
You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash—known as boot—will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.
One of the main ways that people get into trouble with these transactions is by failing to consider loans. Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property that you receive in exchange is only $900,000. In that case, you have a $100,000 gain that is also classified as the boot and will be taxed.
Estate Planning: Tax liabilities end with death, so if you die without selling the property obtained through a 1031 exchange, your heirs won’t be expected to pay the tax you postponed paying. They’ll inherit the property at its stepped-up market-rate value, too. These rules mean that a 1031 exchange can be great for estate planning.