Swapping homes is not just a good idea for a makeover reality show. Knowledgeable real estate investors can sell one property and buy another without having to pay federal capital gains taxes on the transaction, at least not right away.
The capital gains tax from the sale can be deferred until the replacement property is later disposed of. How? By using a “like-kind exchange,” nicknamed a “1031 Exchange” from the IRS code section.
When a property owner reinvests the sale proceeds into another property, the financial gain has not been realized in a way that generates funds to pay any tax. In short, the owner invested rather than pocketed the proceeds, which otherwise would be taxable.
Investors who manage their real estate portfolios wisely can make money regardless of market cycle ups and downs. Taking advantage of tax-saving strategies such as the 1031 Exchange can further leverage their profits.
“The 1031 Exchange is an excellent tool for building real estate portfolios, and it’s also great for small businesses,” says Hugh Pollard, president-elect of the Federation of Exchange Accommodators. Both properties must be used for business or investment purposes. “For those building a portfolio, deferring tax means the investor has more money available for the purchase of a new property. And for small businesses, it frees up capital to perhaps buy a larger facility or obtain a better location.”
Although anyone who owns investment or business property is eligible for this tax deferral benefit, Renee Collins formerly of RKC Tax and Financial Services, points out that “The IRS has a strict definition for like-kind exchanges that must be adhered to. The property must be within the same general asset class or product class.” In addition, the investor must identify a replacement property within 45 days of the closing of the relinquished property and complete the exchange within 180 days. The IRS also requires that a third-party facilitator handle the financial aspects of the transaction.
Complying with these stipulations has proved challenging for Daniel Parker, who’s been investing in real estate for the past five years. “In 2003, I sold a three-unit housing complex, and made $80,000 in profit. I bought another property with the proceeds,” says Parker, 48, whose accountant later told him he could have potentially deferred paying taxes had it been set up as a 1031 Exchange.
Then in 2005, Parker sold two residential properties. But he waited until he sold the properties before looking for replacements. “The moment you close on the property you are selling, the clock starts ticking,” says Parker, who failed to make the 45-day deadline. He lost the $1,000 fee for the facilitator and had to pay capital gains tax on the $60,000 profit.
Parker is determined to execute the 1031. He says the chance to defer capital gains tax as he builds his real estate portfolio is worth the effort. “Next time I’ll identify at least three properties, so hopefully one of the deals will go through before the deadline expires.”