Real estate investments have been on the rise over the last five years, and investors are increasingly faced with real-estate specific tax issues. With appreciated stock, you can sell your shares over a number of years to spread out the capital gains. Unfortunately, investment real estate is not granted the same luxury; the entire gain amount must be claimed on your taxes in the year the property is sold. In this article, we explain one way to avoid taxes when selling real estate: the Internal Revenue Code Section 1031 exchange.

Dealing with Appreciated Real Estate
One downside of real estate investments is that they are not liquid assets like stocks or bonds. Even in today's booming market, it can sometimes take more than a year to settle a real estate deal. If you've decided to sell your real estate and get out while the getting is good, you may be faced with a hefty tax bill on your gain. You could mitigate this tax burden by controlling the year in which title and possession passes and, therefore, the year in which you report the profit or loss on the transaction. In other words, you can set the transfer of ownership to a year in which you expect to have a lower tax burden. However, if your income is steady and paying tax on the gain looks inevitable, you may want to consider using the IRC Section 1031 exchange. (For further reading, see A Long-Term Mindset Meets Dreaded Capital Gains Tax.)

The 1031 Exchange
The 1031 exchange allows an investor to trade real estate held for investment for other investment real estate and incur no immediate tax liabilities. Under Section 1031, if you exchange business or investment property solely for business or investment property of a like kind, no gain or loss is recognized until the newly acquired property is sold. Keep in mind that Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, evidence of indebtedness and certain other assets.

Fully Tax-Free Exchange
For a tax-free 1031 exchange transaction to occur, certain conditions must be met:

Property must be "like kind" - Properties are like kind if they are of the same nature or character, even if they differ in grade or quality.

Property must be related to business or investment - Exchanged property must be held for productive business or investment use and traded for the same use.

New property must be identified within 45 days - The new property that you intend to receive in exchange for your existing property must be identified in writing within 45 days of the first transfer.

Transfer must take place within the 180-day window - The like-kind property must be received by one of these two dates (whichever comes sooner): within the 180-day period following the property transfer, or by your tax return due date (including extensions) for the year in which you transferred the property.

Let's look at an example:

Example - A Tax-Free 1031 Exchange
Nate purchased an investment land lot four years ago for $50,000. Today, the fair market value of the land lot is $150,000. Nate is ready to sell the lot, but he is not particularly enthused about paying taxes on the $100,000 gain. He finds a seller, Jill, who has a $150,000 rental property for sale that interests Nate. If Nate and Jill agree to trade their properties, the exchange will be tax free under Section 1031 exchange rules. As an added bonus, Nate may even be able to claim depreciation on the building.

Partially Tax-Free Exchange
To be completely tax free, the exchange must be solely an exchange of like-kind property. In a perfect world, finding a property with the same trade value is ideal for the 1031 exchange. However, it's difficult to find an equal exchange and, in many cases, one party ends up kicking in some extra cash to make the deal fair. This additional property or cash received is known as "boot", and this gain is taxed up to the amount of the boot received. When there are mortgages on both properties, the mortgages are netted. The party giving up the larger mortgage and getting the smaller mortgage treats the excess as boot. (For further reading, see Understanding The Mortgage Payment Structure and What is an assumable mortgage?)

Let's consider another example:

Example - A Partially Tax-Free 1031 Exchange
Nate owns a building with a fair market value of $200,000, with an adjusted basis of $100,000 (no mortgage remaining). He exchanges it for Jill\'s building, which has a fair market value of $150,000 (no mortgage), plus $50,000 in cash. What is Nate\'s gain? In this example, Nate receives cash, or boot, of $50,000 in addition to the new property, so he has an actual gain of $50,000 on the exchange.

Rules and Regulations
The 1031 exchange will not allow you to avoid capital gains taxes in all cases. For example, the exchange of U.S. real estate for real estate in another country will not qualify for tax-free exchange status. Furthermore, trades involving property used for personal purposes - such as exchanging a personal residence for a rental property - will not receive the tax-free treatment afforded under Section 1031. Finally, if either party subsequently disposes of the exchanged property within a two-year period, the exchanged property will become subject to tax.

For tax reporting purposes, the basis of the old property is carried over to the new property. This is important to understand in a tax-free exchange, because the taxes due are not forgiven, they are simply postponed until the sale of the new property. In order to record the Section 1031 exchange with the Internal Revenue Service, you'll need to file Form 8824 with your tax return for the year of the like-kind exchange. A tax-free exchange is not recommended if the transaction will result in a loss, since losses cannot be deducted in tax-free exchanges. In these cases, you might be better off selling the asset and using the proceeds to buy the new property. (To learn more, read Selling Losing Securities For A Tax Advantage.)

Selling a Principal Residence
Most of this article is related to the treatment of real estate property used for business or investment, but what about personal residences? If you sell (or exchange) your principal residence at a gain, up to $250,000 of the gain may be excluded from income ($500,000 if married and filing jointly), provided that you owned and occupied it as a principal residence for an aggregate of at least two years in the five-year period ending on the date of sale. There is a two-year waiting period if you claimed another sale within the previous two years. (For more on selling a personal residence, see Is it true that you can sell your home and not pay capital gains tax?)

The increased number of real estate sales since the start of this decade has allowed many people to receive favorable tax treatment from the federal government. As a result, however, a tremendous amount of tax revenue has been lost; new regulations that would make some serious changes to the tax advantages currently available on real estate gains are already circulating in Congress. If you're thinking about selling your real estate assets, it might be a good idea to take advantage of Section 1031 before Congress can make any changes.

For more on real estate investments, see What Are REITs? and The REIT Way.

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