The Real Estate Hack Investors Use to Defer Taxes

Learn how to defer capital gains taxes on real estate investment properties below.

A strategy in which real estate investors delay paying capital gains on a property is by participating in "like-kind" exchanges of properties. The U.S. IRS Internal Revenue Code Section 1031 allows an individual to defer capital gains taxes on real estate bought and sold for investment purposes. A 1031 Exchange (also called a "like-kind” exchange) is a real estate investing strategy that allows investors to exchange an investment property for another property of equal or higher value and defer paying capital gains tax on the profit they make from the sale. Individuals, corporations, partnerships, LLCs, trusts and other entities may set up an exchange of business or investment real estate properties under Section 1031.

Capital gains is the increase in a capital asset's value and is realized when the asset is sold; it's the profits that are realized by selling an investment. An investor can either have no tax or limited tax due at the time of the exchange.

Both properties involved in the transaction must be held for use in a trade or business, or for investment. To qualify as a 1031 Exchange, the properties must be "like-kind." Property for personal use, such as primary residences or vacation homes, and exchanging property outside of the United States for a property within the U.S., do not qualify for a like-kind exchange. However, there is a loophole regarding using a primary residence or vacation home in a 1031 Exchange. You can make your primary or vacation home a rental property. You can rent out your primary home for two years to tenants, or rent out your vacation home for 181 days, then exchange it for an investment property. It is also best practice to hold a replacement property for two years (two tax return seasons) before selling it.

Internal Revenue Code Section 1031 allows only domestic-for-domestic and foreign-for-foreign exchanges. It allows you to sell and replace a foreign property only with another foreign property. So, it is possible to 1031 Exchange a house in Jamaica for another one in Jamaica – or in Portugal or Costa Rica. It just won’t be considered like-kind with any U.S. property.

For New York City residents, cooperative (co-op) units can be utilized in a 1031 Exchange if the unit is used as a rental property. Multi-family homes can also be used as long as there are tenants occupying one or more of the units within the property.

Examples of a 1031 Exchange Include:

• An office building for a shopping mall

• A farm for an apartment building

• A commercial property for unimproved property

• An industrial building for a multi-family property

• A condominium apartment for a warehouse

Properties Not Eligible for a 1031 Exchange Include:

• Inventory or stock in trade

• Stocks, bonds or notes

• Other securities or debt

• Partnership interests

• Certificates of trusts

• Franchises

• Art

• Equipment

• Aircraft

The property exchanged must not be sold to customers in the regular course of business, such as lots held for sale by a developer. Also, the exchange can include like-kind property and cash or property that is not like-kind. If so, there will be taxable capital gains for the elements not like-kind in the year of the transaction. There can be taxable capital gains if the replacement property does not have an equal or greater level of debt than the original property. To avoid this, the exchangor must add cash to make up for the lower level of debt on the replacement property. Multiple replacement properties can also be utilized in the exchange to equal the total amount of the original property.

An exchangor may receive cash or some other type of nonqualifying property in addition to the like-kind property. This is called a boot. A Boot is cash or other property added to an exchange to make the value of the exchanged properties equal. At times it can be difficult to find two like-kind properties of identical value to exchange. One party will commonly contribute cash and/or physical property to make the value of the two sides of the deal equal. In order for a cash boot to be qualified as nonmonetary, the value of the boot should be 25% or less of the total fair value of the exchange.

A person must also disclose the adjusted basis of the property given up and any liabilities that are assumed or relinquished. An adjusted cost base is an income tax term that refers to the change in an asset's book value resulting from improvements, new purchases, sales, payouts, or other factors. You can use your basis to determine depreciation, amortization, depletion, casualty losses, and any gain or loss on the sale, exchange, or other disposition of the property. In most situations, the basis of an asset is its cost to you.

There are rules of engagement if you would like to participate in a 1031 Exchange.

1031 Exchange Rules Include:

• The exchangor has 45 days from the day of closing on a property to have an executed contract on a replacement property

• The commitment must be in writing

• The new replacement property must close within 180 days from the date the exchangor sold the original property

• An exchangor must inform all parties involved in the sale and purchase transactions of properties that it is part of a like-kind exchange

An exchangor can identify a maximum of three replacement properties, and confirm the properties have clear title so there would be no issues with closing on a property. It’s also possible to buy the replacement property before selling the old one and still qualify for a 1031 Exchange. In this reverse exchange scenario, the same 45-day and 180-day time windows apply. To qualify, you must transfer the new property to an exchange accommodation titleholder, identify a property for exchange within 45 days, and then complete the transaction within 180 days after the replacement property was bought.

A qualified intermediary (QI) is used to manage and process a 1031 Exchange. A QI accepts the funds from the sale and manages the contracts. There are no licensing requirements for being a QI; however, you cannot be a "disqualified" individual according to the IRS Code. A disqualified person is a person who has functioned as the exchangor’s agent within a two-year period ending on the date of the transfer of the relinquished property. This agent can include, but is not limited to, the exchangor’s employee, attorney, accountant, investment banker or broker, or real estate broker or agent.

The role of the QI is to step into the exchangor’s position and to prevent the exchangor’s access to funds transferred during the exchange process so as not to violate the like-kind clause.

Additional responsibilities of a QI include:

• Coordinating with the exchangors and their advisors

• Preparing the documentation for the relinquished and replacement properties

• Securing the funds in an insured escrow bank account until the exchange is completed

• Providing documents to transfer the replacement property of the exchangor and disburses exchange proceeds to the escrow account

• Submits a 1099 to the exchangor and the IRS for any gross proceeds paid

If used correctly, there is no limit on how frequently you can do 1031 Exchanges. You can roll over the gain from one piece of investment real estate to another and another indefinitely, essentially deferring the capital gains taxes forever. Also, tax liabilities end with the death of the exchangor. If an exchangor passes away without selling the property obtained through a 1031 Exchange, then his or her heirs won’t be expected to pay the tax that the exchangor postponed paying. The exchangor's heirs will inherit the property at its stepped-up market-rate value, too. This is a great method for estate planning.

I hope this article has provided some helpful tips as you consider real estate investment opportunities in the future or growing your investment portfolio. Please feel free to contact me if you should have any questions. Be sure to follow me on Instagram and TikTok at @Keys2Memories for the latest real estate news and helpful tips. And, please feel free to share this article!

LaShawn Freeman, Douglas Elliman Real Estate Agent

Unlocking new memories, one door at a time.

M: 917.254.3313 / E: lashawn.freeman@elliman.com