Selling investment real estate and deferring tax liability with a 1031 Exchange
What you need to know about selling investment property and delaying the tax obligation
When the owner of investment real estate decides to sell that property, if the profit to be earned on the sale of the property is higher than the original purchase price plus cost of improvements, there can be an obligation to pay capital gains taxes on the difference.
If the owner decides to remain in the real estate investment business, he or she should consider transferring the property under Section 1031 of the Internal Revenue Code. This ‘Deferred Exchange’ provision allows an owner to sell investment real estate (referred to as ‘relinquished property’), then use the proceeds to purchase new real estate (‘replacement property’), and defer the taxes on the sale until a later time.
How to avoid capital gains tax liability with a 1031 Exchange
To successfully avoid capital gains tax liability, the owner cannot simply sell the first property and use the money to purchase a different property. The IRS and the Treasury Department have very strict requirements which must be satisfied in order for to qualify for Deferred Exchange treatment.
The general rules of the exchange are as follows:
- The properties sold and acquired must be held for investment, or for use in trade or business.
- Any real estate can be exchanged for any other real estate.
- The owner is allowed to sell one property and buy two or more, so long as the proceeds from the first property are utilized in the subsequent transactions.
- The proceeds from the sale of the relinquished property must be escrowed with a qualified intermediary, pursuant to a written agreement between the property owner and the intermediary.
- The property owner has 45 days from the sale of the relinquished property to identify, in writing and signed by the owner, the potential replacement property or properties.
- The property owner has 180 days from the sale of the relinquished property to acquire one or more of the identified replacement properties.
- To defer all taxes at each transaction, the owner must purchase a replacement property of equal or greater value than the relinquished property.
- It is possible to sell to a related party but there are additional rules for these situations which require strict compliance.
- The owner that sells the relinquished property MUST be the same entity who purchases the replacement property.
- Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts, and any other taxpaying entity may set up an 1031 exchange.
Keep in mind that the deferred taxes are not eliminated but delayed until the final sale, unless a subsequent 1031 Exchange is completed.
Completing a successful 1031 Exchange can be complicated. Hiring an experienced real estate attorney to oversee the process can help make these transactions less stressful and ensure that tax obligations resulting from real estate transfers are successfully deferred.
Do you have questions about a 1031 Exchange or a real estate transaction? Contact Real Estate Attorney Barbara Craig to schedule a free consultation. Serving clients in the South Bay area including Torrance, San Pedro, Lomita, Harbor City, Carson, Wilmington, Long Beach and other nearby communities.
Photo courtesy Philip Taylor