The IRS Code Section 1031 exchange allows an investor to trade real estate held for investment for other investment real estate and incur no immediate tax liability. 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.
IRS Code Section 1031 will not allow the avoidance of capital gains taxes in all cases. The exchange of U.S. real estate for real estate in another country will not qualify for tax-deferred exchange status. Trades involving property used for personal purposes (exchanging a personal residence for a rental property) will not receive tax-deferred treatment.
Finally, if an exchange is made between related parties and 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 because the taxes due are not forgiven, they are simply postponed until the sale of the new property.
A tax-deferred exchange is also possible if you are selling your investment property at a loss. You must determine if the loss is a "tax loss" or just a personal loss. To qualify as a tax loss, your adjusted basis in the property must be more than the selling price of the property. Your adjusted basis takes into consideration any prior depreciation deductions you have taken.
Let's assume you bought a rental property for $400,000 and over the past 10 years, you have depreciated $100,000 on the building. Your current adjusted basis is $300,000. If you sell your rental property for $350,000, it may seem like a loss, but it’s a $50,000 gain for tax purposes.
The gain is considered an unrecaptured gain and it is taxed at a rate of 25%. However, you could purchase a "like-kind" property in order to avoid paying taxes immediately on your $50,000 gain.
Alternatively, let's assume that you are selling the same home for $250,000. This is a $50,000 tax loss, in addition to a personal loss. Is there still a benefit to a "like-kind" exchange? If you purchase a "like-kind" property for $250,000, your basis in that second property will immediately be $300,000 (your adjusted basis in the first property). This would benefit you when it comes time to sell the second property, because the basis you are taking depreciation deductions from is higher.
For a fully tax-deferred Section 1031 exchange transaction to occur, certain conditions must be met:
- Properties are like-kind if they are of the same nature or character, even if they differ in grade or quality.
- Exchanged property must be held for productive business or investment use and traded for the same use. For example, an exchanged property must not be primarily held for resale.
- The new property to be received in exchange for an existing property must be identified in writing to the seller, within 45 days of the first transfer.
- 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 the tax return due date (including extensions) for the year in which the property is transferred.
To be completely tax-deferred, 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 Section 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 receiving the smaller mortgage treats the excess as boot.
The increased number of real estate sales 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 and Congress frequently reviews the tax code to eliminate 1031 Exchanges. But for now, Section 1031 exchanges for real property remain. (Beginning in 2018, they were eliminated for other types of property, such as collectibles, aircraft, franchise rights, and heavy equipment.)
As always, discuss your plans with a tax professional if you have a rental property you are planning to sell to learn which rules apply to your situation.