Anyone who purchased investment real estate before our nation’s recent housing boom has likely seen significant capital appreciation, with property values jumping from $200,000 to $400,000 in many areas. In addition to appreciation, investment property owners also have the benefit of writing off a portion of the investment in depreciation each year.
Investors contemplating selling such properties could face both a significant capital gains tax on the property’s increase in value and a depreciation recapture tax on the funds that were written off each year.
A handy tool for deferring those taxes is available, thanks to section 1031 of the tax code. A 1031 exchange, also called a “like kind” or tax deferred exchange, is a legal way for investors to defer taxes on gains in property used for business or investment by rolling gains over into another similar, or “like kind,” property.
“Section 1031 was a business decision by the IRS. They wanted to encourage people to keep investing,” Karin Church, vice president of Investment Property Exchange Services, Inc., said. “And if the IRS were to impose capital gain taxes when [people] sold an investment property, that would discourage people from selling, and also as part of that, discourage them from going out and buying more property. So what the IRS is looking for…is a continuation of investment.”
A 1031 exchange is a tax deferral strategy, but there is no limit on the number of exchanges that an investor can participate in. Many investors continue rolling over their gains through 1031 exchanges until their death, at which time their heirs get the property without paying taxes on the capital gains that occurred during the investor’s lifetime, Church said.
- Property must be used for either business or investment.
- Property must be held for the purposes of long-term appreciation and/or cash flow rather than resale.
- Exchanges must occur between like kind property (for example, U.S. investment property can be exchanged for other U.S. investment property).
- Unless all steps in the exchange will occur on the same day (which is very difficult to accomplish), a third party called a qualified intermediary (QI) or exchange accommodator is needed in order to maintain the appearance of an exchange. QI fees range from $500 to $1,500 for a standard exchange.
To get full tax deferral:
- Replacement property must be of equal or greater value to relinquished property.
- Equity from relinquished property must be rolled over into replacement property.
- Investor must incur equal or greater debt on replacement property, although it may be possible to offset that debt with an infusion of cash instead.
- During the escrow process on the property the investor is selling, the investor contacts a QI and they draw up an exchange agreement.
- The property being sold, called the relinquished property, closes and the proceeds go to the QI for holding.
- Within 45 calendar days of closing on the relinquished property, the investor officially identifies at least one potential replacement property (usually up to three). If multiple relinquished properties are being exchanged, deadlines are based on the date of the first property to close.
- Within 180 calendar days of closing on the relinquished property, the investor must close on at least one of the potential replacement properties identified in the first 45 days. (If the end of the 180 days would be after the investor’s deadline for taxes—usually April 15—the deadline will be the tax deadline rather than the 180 days.)
- Upon closing on the replacement property, the intermediary wires the necessary funds and assigns the property back to the investor and the exchange is complete.