Real estate investments have performed particularly well over the last five years, creating some unique tax issues for property owners. For instance, should you decide to sell your shares of appreciated stock, you have the option of spreading the transactions out over time, to better manage your capital gains tax burden. This isn’t possible with investment real estate, so the entire profit must be claimed on your taxes during a single tax year. Here, we will offer one way to avoid taxes when selling real estate: the Internal Revenue Code Section 1031 exchange.
Real Estate Appreciation
Real estate investments simply cannot match the liquidity of other financial assets – such as stocks and bonds – and it can sometimes take over a year to sell, even in today’s booming market. If you’re looking at a substantial gain (and therefore a hefty tax bill), you can mitigate the financial damage by settling the sale during a year when you have less income from other sources. If your income is always steady from one year to the next, however, you may wish to use the IRC Section 1031 exchange.
Under Section 1031, if you exchange business or investment property solely for business or investment property that is of “like kind”, no gain or loss is realized from the exchange. This allows investors to trade investment real estate without incurring any immediate tax liabilities.
Completely Tax-Free Exchange
Several conditions must be met in order to qualify for a tax-free 1031 exchange:
- Properties must be like-kind – meaning that they must be of the same nature or character, even if they are of a different grade or quality.
- The exchanged property must be owned for productive business or investment purposes.
- The new property you plan to acquire in exchange for your current property must be identified in writing within 45 days of the initial transfer.
- You must take ownership of the new property within the sooner of 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.
Partial Tax-Free Exchange
The only fully tax-free exchange is one involving like-kind property. Ideally, you should acquire a piece of real estate that has precisely the same value as your own, but you’re unlikely to find such a deal. One property will almost certainly be worth more than the other, requiring one of the parties to contribute some cash to even out the exchange. This extra cash is known as “boot”, and it is still subject to taxation. When both properties are mortgaged, the mortgages are netted against each other, with the party giving up the larger mortgage – and getting the smaller one – treating the excess as boot.
The 1031 exchange won’t allow you to avoid capital gains taxes in every instance, since the exchange of US real estate for offshore property won’t qualify for tax-free exchange status. Nor will trades involving property used for personal purposes, such as swapping a personal residence for a rental property. Lastly, if either party disposes of the exchanged property within two years of the exchange, the exchanged property becomes taxable.
The boost in real estate sales during the last few years has allowed many people to receive favorable tax treatment from the federal government, and a tremendous amount of tax revenue has been lost as a result. New regulations that make significant changes to the tax treatment of real estate gains are already circulating in Congress. If you’re considering the sale of your real estate assets, now may be the time to take advantage of Section 1031 – before Congress can make any changes.
The information herein is general in nature and should not be considered insurance, legal or tax advice. Please consult with an insurance legal or tax professional for additional information on specific situations.
Investment advisory services provided by Werba Rubin Wealth Management, LLC (“Werba Rubin”). Securities transactions are offered through a non-affiliated entity, Loring Ward Securities Inc., member FINRA/SIPC.