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Trade Up Tax Free: Avoid Capital Gains Tax with a 1031 Exchange

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One of the biggest advantages of investing in real estate is that it receives very favorable tax treatment in the U.S. For example, if you sold $100,000 worth of Microsoft stock and made $60,000, you'd be taxed on that $60,000, even if all you did was turn around and reinvest it in Apple stock (and that stock would have to perform very well to make up for the government snagging $20,000 right off the top). However, real estate investing doesn't work that way -- if you made a $60,000 profit on a property sale, you could reinvest that money in another property, and defer every penny of tax on the gain.

What Is a 1031 Exchange?

A 1031 exchange, also called a "like-kind" exchange, refers to the section of the Internal Revenue Service (IRS) Code that governs it. For tax purposes, "like-kind" simply means investment property. You can exchange a rental house for a farm, a commercial building, or even a mine. Even though the transaction is referred to as an "exchange," you don't directly trade property with someone else.

How Does a 1031 Exchange Work?

To take advantage of a 1031 exchange, when you sell a property, you have to reinvest the proceeds into another qualified property. This can be done simultaneously at closing, after the sale of the property (this is commonly called a Starker exchange), or even before the sale of your property (this is called a reverse 1031 exchange). There are three requirements:

  • You can take nothing, and experience no material gain from the sale;
  • The purchase price on the new property must at least equal the net proceeds from the sale of the old property;
  • At no point can you have access to the proceeds -- the property sale and replacement must be facilitated by a qualified intermediary.

What Is a Qualified Intermediary?

To keep your hands clean (metaphorically), you or your associates can't have access to the proceeds of the sale of your investment property, ever. Everything has to pass through a Qualified Intermediary (QI). Title companies, law offices, accountants and others may perform this function, but it's probably best to use a firm that only takes on this kind of business. The Internal Revenue Code contains rules about who can and can't function as your QI. The QI cannot be someone with whom you have had any business or family relationship before the transaction. For example, you can't use your realtor or your attorney or your brother-in-law. The QI has to be someone whose only contact with you is in the context of providing intermediary services for a 1031 exchange.

Duties of Your Qualified Intermediary

The QI facilitates the exchange without taking title to any of the properties. The QI performs several functions, including:

  • Taking the proceeds of the original sale directly from the closing agent;
  • Holding them until they are needed to purchase the replacement property;
  • Delivering the money to the closing agent, who delivers the replacement property deed directly to you.

The QI also completes several tax forms, including:

  • The 1031 exchange agreement, a contract between you and the QI that sets out the rules and guidelines;
  • The assignment, a form which officially puts the intermediary in your place to sell the property;
  • The notice, which goes to the party on the other side of the transaction, advising that the transaction is a 1031 exchange. This is to establish proof that the 1031 exchange was in place at the closing.

How a 1031 Exchange Affects Your Real Estate Contracts

It's a good idea to make completing the sale or purchase by certain deadlines a requirement of your real estate purchase agreements. The buyer and seller should be willing to cooperate with you on the exchange. There are timing issues, so you don't want to lose your tax benefit because a real estate agent, seller, mortgage lender or buyer doesn't do what's needed to be done, causing you to miss a deadline. When you have sold your property, you have 45 days to identify in writing prospective replacement properties, and 180 days to close on the transaction. There are no extensions, and there is no appealing to the IRS. That means you need to have lined up your own mortgage, as loans for investment properties can be harder to get and you want your exchange to go smoothly.

Gina Pogol has been writing about mortgage and finance since 1994, and is an active real estate investor. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian, and as an accountant for Deloitte.

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