Deferring capital gains taxes on investment real estate
Presented by: Timothy Donovan
Do you own an apartment or office building, undeveloped land, or other investment real estate that you’d like to sell?
If the prospect of paying a large tax bill on your property’s appreciation is holding you back, there may be a tax-wise solution for your dilemma.
It’s called a “like-kind,” IRC Section 1031 exchange. Instead of selling your property, you swap it for another property of similar value.
If you follow the tax law’s rules, you’ll be able to dispose of your property without reporting an immediate taxable profit.
Instead, you’ll defer the capital gains tax impact. You’ll protect the gain on the property you own now for as long as you hold the replacement property. In addition, you keep your current property depreciation recapture.
How To Qualify:
To achieve a tax-deferred exchange of real estate, both your property and the property you exchange it for must be held as an investment or used in a business.
The tax code calls this “like-kind” property, although the label is somewhat misleading because you have a lot of flexibility in choosing property to replace yours.
For example, swapping a Chicago office building for a Dallas manufacturing plant could qualify for like-kind exchange treatment. So could exchanging a canning factory in California for unimproved land in Delaware.
In fact, you’re free to swap any type ofinvestment or commercial real estate for any other. You just can’t trade domestic for foreign properties.
Making Your Deal:
You don’t necessarily have to swap your property directly. You can use a“qualified intermediary,”and they are easy to locate online. Working within the requirements of the tax code, these firms make it practical for you to find a suitable property and arrange an exchange.
So, if you own a professional building, you might be able to acquire an apartment building that’s for sale, even if the owner isn’t interested in your building.
A third person who does want your building could first buy the apartment building and then swap it with you in a like-kind exchange.
Avoiding Timing Problems:
A qualified intermediary also lets you work around timing differences. There are strict time frames that apply for completing the steps in the transaction.
The proceeds of the sale must be invested in a like kind asset within 180 days of the sale and a replacement property must be identified within 45 days of the sale.
In addition, to qualify as a 1031 exchange, the taxpayer cannot have "constructive receipt" of the proceeds of the sale, and a qualified intermediary is necessary.
A qualified intermediary role is to hold the proceeds of the sale and to buy the replacement property on behalf of the taxpayer.
Evening Out the Trade:
Most likely, you won’t find a replacement property with a market value exactly matching yours. Or taking over another property owner’s mortgage might be part of the deal.
While transactions like these do qualify for favorable tax treatment, typically some taxable gain must be recognized.
Equipment Trades:
Like-kind exchanges are not confined to real estate. It’s also possible to swap equipment or other assets used in a trade or business. Personal residences, stocks, bonds, and inventory don’t qualify for a like-kind exchange.
If the thought of paying a large, immediate capital gains tax is preventing you from selling your property, consult with your professional advisors for more information.