Swapping like-kind assets could allow you to defer capital gains taxes.
Sometimes it makes sense to defer certain tax liabilities — to reduce your tax bill during your peak earning years when your income and tax rate are typically higher.
One way to do that is by swapping one property asset for another, using Section 1031 of the Internal Revenue Code. This section contains special rules for transactions involving the swap of one real property asset for another.
By meeting certain IRS requirements, these “1031 like-kind exchanges” allow the deferral of the capital gains taxes. For example, if you purchased an apartment complex for $1 million and its value increased to $2 million, you would be required to pay capital gains tax on the $1 million appreciation, were you to sell the business. However, if you used the $2 million to buy a plot of land nearby, you could claim a 1031 exchange and defer the capital gain from the apartment complex.
What’s not eligible under 1031 exchange rules? Stocks, bonds, partnership interests, and inventory, along with vacation homes and personal residences.
The rules for what can be included in these exchanges changed with the passage of the Tax Cut and Jobs Act. Previously, Section 1031 included personal property — such as collectibles, airplanes, and yachts — so long as the exchange was for property of the same nature, character, or class. If you purchased and exchanged personal property assets prior to 2018, they may still be eligible.
Starting in 2018, exchanges are limited to real property, such as single and multifamily rentals, office buildings, and other commercial real estate. Your tax professional and financial advisor can help determine whether your property is eligible for a 1031 exchange.
Keep in mind that certain assets, such as stocks, bonds, partnership interests, inventory, vacation homes, and personal residences are not eligible regardless of when they were purchased or exchanged.
A 1031 exchange offers two benefits:
- It can minimize your tax obligation, depending on the details of the transaction.
- Second, there can be potential improvement of cash flow by deferring capital gains tax.
You can identify up to three other properties for one 1031 exchange. To continue our earlier example, you could use the $2 million from the sale of your apartment complex to buy two new apartment complexes at $1 million each.
You need to be careful, though, if mortgages or other loans are involved in the sale or purchase of the property. Section 1031 requires your exchange to be for an equivalent value, and when there are loans or mortgages involved, that can complicate the process and may generate taxable income.
One important caveat requires that you not take possession of the sale proceeds. If you do, it may invalidate the exchange. A qualified intermediary, like a bank, can help with this.
You also need to make sure there is no personal property considered in the real property exchange. For instance, in the earlier example, if part of the value of the exchange comes from personal property, such as the appliances in the building or furniture, that property would be taxable.
Working with a tax professional or financial advisor can help you determine whether a 1031 exchange might help alleviate your tax burden and help you navigate the restrictions if so.
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