A section 1031 Tax-Deferred Exchange lets you do that in effect, deferring your capital gains tax

What does investing in real estate have in common with the game of Monopoly? Winning at both requires acquiring the most valuable real estate by trading less desirable properties for more attractive ones. For real estate investors, it’s easier to finish a winner by understanding the benefits of Internal Revenue Code Section 1031 Tax-Deferred Exchanges. By utilizing this powerful tax strategy, property owners no longer need to leave the outcome up to “Chance.”

Tax-deferred exchanges have been a part of the tax code since 1921 and are a significant tax advantage for Texas real estate investors. One of the key advantages of the Section 1031 Exchange is the ability to dispose of a property without incurring a capital gain tax liability, thereby allowing the earning power of the deferred taxes to work for the benefit of the investor (exchanger) instead of the government. In essence, it can be considered an interest-free loan from the Internal Revenue Service.

Basic tax-deferred exchange requirements

Although many investors mistakenly believe an exchange is simply a swap of properties, most exchanges completed in the 1990s are variations of what is called a delayed exchange. In a delayed exchange under section 1031, the property currently owned is called the relinquished property and must be exchanged for like-kind replacement property. The IRS allows up to 180 days between the sale of the relinquished property and the purchase of the replacement property.

There are a number of requirements, which need to be met to qualify for tax deferral:

Requirement #1: Business or investment use

Both the relinquished and replacement properties must be held for investment or used in a business. The IRS uses the term like kind to describe the type of properties that qualify. Any property held for investment can be exchanged for any other like-kind property held for investment. This definition covers a vast variety of developed and undeveloped real estate. Properties, which are clearly not like kind, are an investor’s primary residence or property held for sale. The relinquished and replacement properties need not have identical functions (e.g., both be residential rentals or commercial strip centers).

Requirement #2: Identification time limits

The IRS requires an investor to identify the replacement property (or properties) within 45 days from closing on the sale of a relinquished property. The 45-day identification period begins on the closing date, and the replacement property must be properly identified in a letter signed by the exchanger and received by the qualified intermediary.

Exchangers have a number of ways to properly identify properties. They may identify up to three targeted properties without regard to their total market value (three-property rule). Alternatively, they can identify an unlimited number of replacement properties if the total fair market value is no more than twice the value of the property sold (200% rule). As a final option, an exchanger can break both of these rules if they acquire 95% of the aggregate fair market value of all identified replacement properties.

Requirement #3: Closing time limits

The exchanger must close on the replacement property by the earliest of either 180 calendar days after closing on the sale of the relinquished property or the due date for filing the tax return for the year which the relinquished property was sold (unless an automatic filing extension has been obtained).

Example: If an exchanger closes on the relinquished property on Dec.27, the 180-day period will end after April 15 (Tax Day). In this case, the exchanger would have to close on the replacement property (or request an extension of time to file their taxes) by April 15.

Exchangers may, of course, choose to close both transactions within a shorter period of time, thereby avoiding the potential hardship of the 45- and 180-day time limits.

Requirement #4: Working with delayed exchanges

The most common exchange format, the delayed exchange, requires investors to work with an IRS-approved middleman called a qualified intermediary. The qualified intermediary actually documents the exchange by preparing the necessary paperwork (exchange agreements), holding proceeds on behalf of the exchanger, and structuring the sale of the relinquished property.

When are capital gains taxes paid?

Maybe never. Many investors mistakenly believe they will “have to pay the taxes sometime,” so they might as well just sell. Quite often, this is a bad decision. The tax on an exchange is deferred and is only recognized when an investor sells the property for cash instead of performing an exchange. Investors can continue to exchange properties as often and for as long as they wish, moving up to better investments and putting off the taxes for many years. The extra purchasing power generated by deferring taxes will produce increased income and larger investment holdings.

If someone dies before selling his or her property, the IRS waives the capital gain tax bill completely. Under IRS rules, an exchanger’s heirs receive what is known as a step-up basis. Their basis in the property for purposes of calculating capital gains is the property’s value at the time of the exchanger’s death. If the heirs sell the property the day after inheriting it, they’ll have little or no taxable gain.