Deferring tax on income or gain is almost as effective as avoiding it altogether. That's because the longer you can defer payment, the lower your effective tax rate. And for US taxpayers, there's no better way to take advantage of tax deferral than with a strategy called a 1031 exchange.
This cryptic name refers to the section of the Internal Revenue Code that lets you defer tax on exchanges of a "like-kind" investment property.
Section 1031 lets you defer paying federal capital gains taxes when you sell real property and buy "like kind" property through an approved exchange transaction. As a bonus, you may be able to deduct tax for depreciation on the new property without needing to recapture depreciation on the one you sell. To have a fully deferred exchange, the property you acquire must be of equal or greater value compared to the property you sell.
A 1031 exchange is amazingly flexible because almost any like-kind investment property can be exchanged: houses, apartments, condominiums, industrial property, and even raw land. For instance, you can exchange raw land for a shopping center, a condo for a coffee shop, or an office building for an apartment complex.
But 1031 exchanges aren’t as flexible as they once were, thanks to last December’s tax reform bill. While you could once exchange like-kind assets other than real property, that opportunity ended on December 31, 2017. So you can no longer make tax-deferred exchanges of assets such as precious metals or crypto-currencies.
But the 1031 exchange remains an effective wealth management strategy. Here's a simple example of the power of this strategy.
Let's say that in 2010, you purchased a parcel of raw land in Arizona for $500,000, anticipating that the state would build a highway near it, which would greatly increase its value. In 2016, the state announced just such a project. Within weeks, the value of the property tripled to $1.5 million. You decide to cash in by exchanging the land for a used car lot in Phoenix. If you simply sold the Arizona property, you’d owe as much as 23.8% ($230,000) in federal capital gains tax. But with a 1031 exchange, you can defer payment of the entire tax obligation.
There are more advanced 1031 exchange strategies to consider as well:
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The reverse exchange. This technique allows you to lock up a replacement property before you sell the original property, so it's not sold to another party. Or you may want to eliminate the pressure of identifying your like-kind replacement property within the required 45 calendar days.
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A "tenants in common" (TIC) exchange. With this type of exchange, you can exchange an existing property into a fractional interest of another property. The property you hold a fractional interest in might be part of a much larger project than you might otherwise be able to target. You can also diversify your investment into several different properties with a TIC exchange.
A 1031 exchange could be useful for non-tax reasons as well. For instance, you might get access to improved financing options by exchanging property that isn’t easily financed for property that can be mortgaged. You might also consider exchanging non-income-producing or highly appreciated property for property that will generate higher cash flows. If you’re close to retiring, you might want to exchange several smaller properties for a single larger property to simplify your management responsibilities.
Naturally, for a strategy this flexible, there are some important rules to follow. To facilitate compliance with these rules, you should use the services of a middleman – what the IRS rules call a Qualified Intermediary (QI). The QI—typically a bank or a company that specializes in 1031 transactions — has several functions. It sells your property on your behalf, holds the funds for you, buys the new replacement property, and then transfers the deed to you. You pay the QI to ensure that the exchange satisfies the IRS rules.
Your QI can't be anyone considered your “agent,” such as your lawyer, real estate broker, employee, etc. unless this person has not represented you within the past two years. It also can't be a family member.
Keep in mind that QIs occasionally go bankrupt, especially during severe real estate downturns. For instance, in the midst of the recession in 2008, I learned of a couple who hired a QI to execute a $1.5 million real estate transaction. This represented about $1 million in deferred profits. Before they were able to conclude the transaction, the QI declared bankruptcy. Unfortunately, the company hadn’t bothered to put the $1.5 million in a segregated account. The couple lost their entire $1.5 million. Then the IRS hit them with a bill for $150,000 in federal taxes since they were unable to complete the exchange.
For that reason, it’s always best to use an institutional QI, such as a major bank. Even if the bank goes under, the assets in the segregated account should still be secure.
In addition:
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Strict time limits apply. You must sign the exchange agreement with your QI before closing on the first property you're selling. Within 45 days after closing on the first property, you must identify one or more replacement properties. You have a maximum of 180 days from the closing date of the first property sale to close on the replacement property or properties.
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The exchanged properties must all be either in the US or overseas. You can't exchange a domestic property for a foreign one, or vice-versa.
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The exchange must be for properties held for use in a trade or business or for investment. That means you can’t exchange your personal residence unless you have held it as an investment property for the last year and one day before you sell it. However, it may be a better deal tax-wise to treat the transaction as the sale of a personal residence. That’s because the Tax Code allows you to exclude up to a $250,000 capital gain in your personal residence ($500,000 for a married couple filing a joint return) from tax. But if there’s additional gain, you may be able to roll over the remainder of the gain in a 1031 exchange.
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You must report the exchange to the IRS. The form used for this purpose is Form 8824. Instructions for this form are at this link.
As well, there are numerous tax traps that could prevent you from exploiting the full power of this strategy. You’ll want to consult with a real estate lawyer with extensive experience in this area before proceeding.
