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. However, if a homeowner used the IRS Section 1031 exchange, they can defer the amount into a similar investment vehicle.
Managing the Initial Sale
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.
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 a 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.
Note that, beginning in 2018, the new 2017 tax legislation has limited these exchanges to real estate – 1031 exchanges of other property, such as artwork, are no longer permitted. For more clarity, refer to the IRS.
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. 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.
Fully Tax-Free Exchange
For a tax-free 1031 exchange transaction to occur, certain conditions must be met:
The 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.
The 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.
The 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.
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.
The Bottom Line
The increased number of real estate sales since 2010 has allowed many people to receive favorable tax treatment from the federal government. As a result, a tremendous amount of tax revenue has been lost. For now, 1031 exchanges for real property remain. (As discussed above, beginning in 2018, they were eliminated for other types of property, such as collectibles, aircraft, franchise rights, and heavy equipment.)