Real estate investments have been rising over the last five years, with investors becoming attracted to their value but also preferring to avoid the increasing problems that come with real estate specific taxes. Capital gains tax is among them. With corporate stocks, it is possible to sell the shares over a period to spread out the tax on the gains, but this is not applicable to real estate properties – the entire amount must be claimed on the taxes in the year the property was sold. One of the most prominent ways to avoid capital gains tax on the sale of real estate is the Internal Revenue Code Section 1031 exchange.
One of the main downsides of a real estate investment is that they are not liquid assets. It can take a year or more to settle a deal and selling it while the value is high can result in a significantly larger tax value than the potential profit. The easiest way to mitigate this problem is to control the year in which the title and formal possession of the property. This allows people to set the year of the transfer of ownership to one which is more likely to have a lower tax burden. This does not completely mitigate the capital gains tax, but the right timing can significantly reduce the amount that needs to be paid. However, if paying a large tax on the gains seems inevitable, a 1031 exchange is still a valid option.
The 1031 exchange allows investors to trade real estate held for the purpose of investment for other investment real estate and incur no immediate tax liabilities. Under Section 2031, those who exchange property used for investment or business purposes solely for business or investment property of a similar kind will not be subjected to capital gains tax, as there is no legally recognized gain or loss until the new property is sold. Note, however, that Section 1031 is limited and does not apply to the exchange of inventories, stocks, bonds, notes, evidence of indebtedness and other types of assets.
There are certain conditions that must be met to achieve a full tax-free exchange under the rules of Section 1031. The properties must first be of “like kind” – this means that they must be of the same nature or purpose, even if there is a difference in grade or quality. The properties must also be related to business or investment, and must be held or used for the production or purpose of such. The properties must also be traded for the same use.
The time interval for the transfers is also limited. The property that is to be received must be identified within 45 days of the first transfer. This must be identified in writing during the given 45-day window. The transfer itself must be received within the 180-day period following the property transfer or by the tax return due date for the year in which it was to be transferred, depending on which comes sooner.
Note that there are certain restrictions on the applications of a Section 1031 exchange. It does not cover exchanges between property in the US with one from another country. Property involving personal purposes, such as rental property or a personal residence, will not be included under the limitations of a 1031 exchange.