The 1031 Exchange for Real Estate Investors
Avoiding Capital Gains Taxes
Avoiding Capital Gains Taxes on Real Estate Investments
The 1031 exchange was not around in Ben Franklin's time. He said "In this world nothing can be said to be certain, except death and taxes." Well, death is still certain, but those holding real estate for investment can avoid capital gains taxes altogether. Or at least their heirs can. That's why investors say you can "swap till you drop."
What the IRS Says
Here's what the Internal Revenue Code, Title 26, Section 1031 says: "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment." Property of like kind simply means other real estate, and does not require a land-for-land or office-for-office exchange.
That means that if your transaction comes within 1031, you’ll either have no tax or limited tax due at the time of the exchange. There’s no limit on how many times or how frequently you can do a 1031. You may realize a profit on each swap, however, you avoid tax until you actually sell for cash. Then you’ll hopefully pay only one tax, and that at a long-term capital gain rate.
Swap Till You Drop
So we know that we can sell some investment land and purchase office rental property, while deferring capital gains on our profit from the land sale. Basically, there are three requirements for this to work. The investor must be
- Selling investment property and not a personal residence;
- Exchanging properties of like kind, meaning simply any other real estate; and
- Actually exchanging properties by meeting certain deadlines and time frames.
What You Can't Do
The IRS says that a 1031 exchange cannot be used to exchange:
- Stock in trade or other property held for resale;
- Stocks, bonds, or notes;
- Other securities or evidence of indebtedness or interest;
- Interests in a partnership; or
- Certificates of trusts or beneficial interests.
Growing Your Holdings with the Government as Your Partner
If your real estate sale and subsequent purchase qualify for a 1031 exchange, also called a like-kind exchange or a Starker, and you meet the requirements of time frames, you can use the government's money to grow your holdings.
As the value of your investment properties increase, you can repeatedly trade up for increased value or rental income, deferring capital gains taxes all the way. The money that would have paid capital gains taxes for each transaction is plowed into the next transaction as equity in the new property. The government becomes your partner in your growing real estate portfolio.
Of course at some point, a final sale without a 1031 exchange would trigger the requirement for payment of accumulated capital gains or long-term capital gains. However, should the investor die, the cost basis of the last property would be adjusted to current value. Your heirs would not be liable for those accumulated capital gains taxes. Ben Franklin would have loved this.