1031 Exchanges: Legal Tax Evasion?
“‘In this world nothing can be said to be certain, except death and taxes.” – Ben Franklin
Poor Ben. He never heard about 1031 property exchanges. If he had, he would have known that using 1031 exchanges would have let him delay paying capital gains taxes on investment property indefinitely. In fact, the 1031 exchange – so named for the section of the tax code that describes it – has been the basis of wealth for many real estate investors. And like any tax rule, a 1031 exchange is fairly straightforward – unless it isn’t.
Basically, it allows an investment property owner to exchange the property they own for another property of “like kind” in order to postpone paying capital gains taxes that typically accompany the sale of real property. Notice these exchanges are for investment property, and not a personal residence (for which you may be completely exempt from capital gains when you sell, by the way). And to be clear, you’re not actually avoiding paying taxes- just deferring those taxes until the investment is sold without an exchange.
To understand a 1031 exchange, first you need to understand what’s meant by “like kind.” While it used to mean the properties had to be more or less identical – i.e., a duplex for another duplex – the definition is more relaxed today. In general, 1031 exchanges can take place between two properties that are either held for business or for investment. Property being held for sale, such as vacant land under development and so-called fix-and-flip deals, do not count. In most cases, vacation or second homes that are not rented out also are ineligible, although there is a use test in the tax code to determine eligibility in some cases.
The primary benefit, as noted, is that you can defer paying capital gains taxes, and what that means is that you can use that money that would have been diverted toward taxes to acquire a more valuable property than what you originally owned. For instance, if you sell an investment property that’s increased in value by $100,000 since you purchased it, a simple capital gains tax on that property would be 15 percent, meaning you’d only have $85,000 to put toward your next investment property. But if you exchange it, you calculate the exchange based on the entire value, including the full $100,000 in gains.
Here’s another little neat benefit: If you sell your investments eventually, you will be subject to capital gains taxes that have accumulated; but – and this is a big one – if you die and leave the investment to your hers, the value is adjusted to the current cost basis, which means your heirs would not have to pay those accumulated capital gains taxes. (Can’t you just feel Ben spinning in his grave?)
As noted, there are time limits and deadlines that have to be adhered to when completing an exchange, so it’s a good idea – especially if this is the first time you’re using the exchange – to get the advice of a seasoned real estate or mortgage professional to ensure all deadlines and requirements are met. The 1031 exchange has helped a lot of investors build massive portfolios. Who knows? You could be next.