Avoid Capital Gains Tax by Using a 1031 Tax Deferred Exchange

When a real estate investor typically sells an investment property, they are taxed on any gain realized from the sale.  However through a 1031 tax deferred exchange a real estate investor can sell an investment property and buy a new property with the gain or profit from the sale and not owe taxes on the sale immediately.

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.  A tax deferred exchange is a method by which a real estate investor trades one or more relinquished properties for one or more replacement properties of "like-kind," while deferring the payment of federal income taxes and some state taxes on the transaction.

The IRS states specific guidelines that must be followed to qualify for the benefits of a 1031 tax deferred exchange.  The primary guideline is that the investor is not allowed to receive any material benefit from the sale of the property, must clearly identify potential replacement properties and complete the transfer within certain timeframes.

Qualified Intermediary

If the real estate investor takes control of cash or other proceeds from the sale before the exchange is complete, the exchange can be disqualified and all gain is immediately taxable.  One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary to hold these proceeds until the exchange is complete.

A qualified intermediary is an independent party who facilitates tax deferred exchanges.  The qualified intermediary cannot be the taxpayer or a disqualified person such as your lawyer or accountant or another family member.  Acting under a written agreement with the real estate investor, the qualified intermediary acquires the relinquished property and transfers it to the buyer, then they hold the sales proceeds, and finally they acquire the replacement property and transfer it to the taxpayer to complete the exchange within the appropriate time limits.

Identifying Property

The real estate investor has 45 days from the date of the sale of the relinquished property to identify potential replacement properties.  The identification of the replacement properties must be in writing and signed by the investor and delivered to the qualified intermediary.  The replacement properties must be clearly described in the written identification which usually requires a legal description and street address.

You can identify more than one property as the replacement property.  However the maximum number of replacement properties that you may identify without regard to fair market value is three properties.  You may identify any number of properties provided that the total value of these properties is not more than 200% of the value of the original property you are selling.

Time Limits

If you have correctly complied with the identification phase of the exchange, you have up to 180 days from the date of the sale of the relinquished property to complete an exchange, but the period may be shorter.  The shorter period is because you have 180 days from the sale of the relinquished property OR the due date of the investor's tax return (including extensions) for the year in which the transfer is made.  There are no extensions for this time limit.

Summary

The 1031 tax deferred exchange is a great way to maximize your wealth.  The taxes you would have paid to the government are now working to earn you money and this provides a financial leverage to greatly increase your net worth. 

This article provides a basic introduction to a 1031 tax deferred exchange and should not be relied upon as legal advice.  If you want to complete a 1031 tax deferred exchange you need to consult a competent professional.