How to Sell a Property and Defer Capital Gain Taxes
An intro to the 1031 tax exchangeBy S.M. Oliva | Reviewed by Canaan Suitt, J.D. | Last updated on January 11, 2024 Featuring practical insights from contributing attorney Blaine S. Schwartz
Use these links to jump to different sections:
- Deferring Capitals Gain Taxes Through a 1031 Exchange
- Four Essential 1031 Exchange Rules
- Find an Experienced Attorney for Legal Help
If you buy or sell real estate, 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.
Deferring Capitals Gain Taxes Through a 1031 Exchange
However, the 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 IRS Internal Revenue Code.
Under the 2017 Tax Cuts and Jobs Act, 1031 exchanges apply to real property, whether improved or unimproved. Taxpayers can no longer use like-kind exchanges for personal property, such as machinery used in a business.
Four Essential 1031 Exchange Rules
As with all aspects of the Internal Revenue Code, the rules governing 1031 exchanges are quite complex. This is why you should always consult with a qualified tax attorney before attempting an exchange. But here are a few basic rules to keep in mind:
1. Real Property Only
A 1031 exchange is only valid for a like-kind exchange of real property. Fortunately, all real property in the U.S. is considered to be 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 at Lippes Mathias in Buffalo, New York. “The answer is ‘no,’ because an interest in an entity is considered personal property, which cannot be exchanged for an interest in real property.”
2. Strict Time Limits to Complete a 1031 Exchange
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.
3. The Properties Can’t Be for Personal Use
Both the exchanged and relinquished properties must be investment properties or held for a “productive use in a trade or business.” In other words, neither property can be your personal primary residence.
4. Consider Both State and Federal Tax Laws
You need to consider both the state and federal tax implications of a 1031 exchange. For example, New York State imposes its own income tax on capital gains, but also grants exemptions for qualified 1031 exchanges, which requires filing separate forms with the state.
Find an Experienced Attorney for Legal Help
Again, this is simply a brief overview of how 1031 exchanges work. In practice, a 1031 exchange may involve real estate investors buying and selling multiple new properties 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 a qualified intermediary with a history of providing accurate advice and assistance. This will make life vastly easier for you as a seller.”
Visit the Super Lawyers directory to find an experienced real estate tax lawyer in your area for tax strategies and legal advice in the property exchange process. For more information on this area, check out our overview of real estate laws.
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