How to Sell a Property and Defer Capital Gain Taxes
The ins and outs of a 1031 tax exchange in Upstate New York
on December 18, 2018
Updated on March 3, 2022
If you buy or sell real estate in New York, you need to be aware of the potential tax implications. Normally, the “capital gain” on the sale of real property is subject to federal and state income tax. In other words, if you buy a house for $100,000 and sell it 10 years later for $250,000, you need to pay income tax on the capital gain of $150,000.
But federal tax code allows real estate owners to defer capital gains taxes in situations where the proceeds from the sale of one property are used to purchase another, similar property. This is known as a 1031 exchange–a reference to the appropriate section of the Internal Revenue Code–and as of 2018, it only applies to real property, whether improved or unimproved. Prior to January 1, 2018, taxpayers could also conduct 1031 exchanges of certain qualifying personal property, such as machinery used in a business.
Basic Rules and Bottom Line
As with all aspects of the IRS Internal Revenue Code, the rules governing 1031 exchanges are quite complex. This is why you should always consult with a qualified upstate New York tax attorney before attempting an exchange. But here are a few basic rules to keep in mind:
- A 1031 exchange is only valid for a like-kind exchange of real property. Fortunately, all real property in the U.S. is considered of a like kind. This means you can sell a business property in Albany and use the proceeds to buy a piece of farmland in Oswego County, and it would qualify as a 1031 exchange. However, you cannot exchange U.S. real property for non-U.S. real property. “Clients frequently ask if they can exchange ownership interests in an entity such as an LLC for a fee interest in real estate,” says Blaine S. Schwartz, a real estate attorney in Buffalo. “The answer is ‘no,’ because an interest in an entity is considered personal property, which cannot be exchanged for an interest in real property.”
- There are strict time limits to complete a 1031 exchange. The clock starts to run when the property being sold is transferred to the buyer, or the date the new deed is recorded, whichever occurs first. From that point, the seller must purchase the like-kind property within 180 days, or before filing their tax return for the tax year when the first property was sold, whichever occurs first. The party making the exchange must also “identify” the like-kind property within 45 days of transferring the first property. “Most clients are concerned about the timing of 1031 exchanges, because if the deadline for identifying replacement property or closing on that replacement property falls on a Saturday, Sunday or a holiday, the deadline does not roll over to the next business day,” adds Schwartz.
- Both the relinquished and exchanged properties must be held for investment or “productive use in a trade or business.” In other words, neither property can be your personal residence.
- You need to consider both the state and federal tax implications of a 1031 exchange. New York State imposes its own income tax on capital gains. But New York also grants exemptions for qualified 1031 exchanges, which requires filing separate forms with the state.
Again, this is simply a brief overview of how 1031 exchanges work. In practice, a 1031 exchange may involve multiple properties bought and sold over a short period of time. Of the exchange, Schwartz says: “There are creative ways to do this, but you need to start the planning process early. Also, make sure you work with an experienced attorney and an exchange intermediary with a history of providing accurate advice and assistance. This will make life vastly easier for you as a seller.”
For more information on this area, check out our overview of real estate laws.