Real Estate: Deferring Capital Gains with a 1031 Exchange

The three most unpleasant words for a real estate investor are “capital gains tax”. However, there is a way to defer this tax for many years and if done right, with some careful estate planning, it might be possible to completely avoid capital gains taxes on investment properties. The strategy begins with the 1031 exchange rule.

A 1031 exchange is a swap of one real estate investment property for another. This swap allows capital gains taxes to be deferred. An exchange can only be made with “like-kind” properties. There is no limit to how frequently you can do 1031 exchanges. You can roll over the gain from one piece of investment real estate to another and another and another. By using the 1031 exchange rule you will avoid paying capital gains tax until you sell the investment property for cash many years later. If done correctly you will pay only one tax at a long-term capital gains rate when you sell off at the end.

To qualify for a 1031 exchange the properties must be of “like kind”. This is not as strict a term as you may think. In fact, you can exchange an apartment building for an empty piece of land. However, when you do exchange depreciable property (i.e. improved land with a building on it) for unimproved land without a building on it then you can trigger a depreciation recapture. That means that the depreciation that you previously claimed on the building will be recaptured and taxed as ordinary income.

There are two timing rules that need to be adhered to when doing a 1031 exchange. The 45-day rule and the 180-day rule. First you must find a qualified intermediary (i.e. a 1031 exchange company). As soon as you sell your property the intermediary will receive the cash. You cannot receive any of the sales proceeds or it will spoil the 1031 exchange. Then within 45 days of the sale you must designate at least 1 property that is to be the replacement; you can designate up to 3 as long as you close on one of them. Within 180 days of the sale, you must close on the replacement property and any left-over cash (“boot”) will come back to you and will be taxable as capital gains.

You will have to consider loans as well in connection with these transactions. For example, if the properties are of equal value, but the one you are selling had a $900,000 loan while the replacement property will have a loan of only $800,000, you will then have a $100,000 gain, which will be considered boot, and subject to capital gains tax.

In 2008, the IRS put a “safe harbor” rule in place that states the IRS will not challenge whether a property is of “like kind” if both the sold property and purchased property were owned by the taxpayer for at least two years before and after the transfer and the property is rented for fair market value for at least 14 days or more for each 12-month period. This will suffice as long as the taxpayer also limits their personal use of the investment property so that it does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the unit is rented for fair market value.

Some investors convert their investment property into their primary residence to take advantage of the $500,000 home sale tax exclusion. However, there are certain rules that need to be followed for this to work. In short, the investment property needs to have been held as an investment for at least 2 years (satisfying the “safe harbor” rule) and then the property must also have been held for 5 years before a sale, in order for the investor to use the home sale tax exclusion. Additionally, you need to live on the property and use it as your primary residence for 2 out of those 5 years. However, investors should be wary of this tactic because it could once again trigger a depreciation recapture.

The downside of a 1031 exchange is that the tax deferral ends when you eventually sell the replacement property. However, with proper estate planning you could avoid the capital gains tax all together. As we all know tax liabilities end with death. Therefore, if you die without having sold the property then the property value will step up in basis to the date of death market value and your heirs will inherit it at this new basis. If they then choose to sell the property their capital gains tax will be calculated from this new basis which should minimize or mitigate their tax.

For further information and to evaluate whether this strategy, when included as part of your personal estate planning, is right for your goals please schedule an appointment by calling (516) 447-0455 or email us at info@mavrospanagoslaw.com.

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Eleni Mavros Panagos, Esq.

Mavros Panagos Law

200 Broadhollow Road, Ste. 207

Melville, NY 11747

(516) 447-0455

www.mavrospanagoslaw.com