Avoiding paying taxes is legal, if you follow the IRS Code. When it comes to real property, doing a 1031 tax-deferred exchange has become a standard tool in the real-estate investor’s toolbox. Long-term creation of wealth in real estate can be done without ever paying any capital gains taxes through utilizing tax-deferred exchange techniques.
This section of the code applies to all types of property, including land, homes, apartments, commercial property and even leasehold property. Investors are generally motivated to exchange for at least one of three reasons:
First, they want to change their investment from one type of property to another type, i.e., sell land and exchange it for income-producing property or sell a property in Tahoe and trade into one in Hawaii.
Second, they may want to sell a property where there is very little or no loan and trade for a much more expensive property with more leverage so that over time there will be greater appreciation.
Third, they may wish to diversify the type of real estate they own, i.e., instead of just rental houses they may want to trade some of their real-estate portfolio into office buildings.
All of these goals could be fulfilled by just selling the investment property and then taking the proceeds after tax and buying the new investment. Unfortunately, this method may cost you approximately 25 percent in capital-gains taxes on your net gain in the property.
Gain generally equals the selling price minus your original purchase price minus whatever depreciation you have deducted. There may also be additional taxes due on any depreciation you have taken on the property. One upside is that the new property you purchase will have a new tax basis for depreciation purposes. When you exchange, the old basis is carried over to the new property and thus you will be getting fewer tax benefits from depreciation; however the benefit of paying no capital-gains tax usually outweighs any benefits that may be obtained by depreciation.
Most 1031 exchanges today are done by using the delayed exchange rules, since closing escrows on two or more properties simultaneously can be difficult to arrange. However, the law only gives you 45 days from the sale of your property to identify the property(s) you are going to exchange into and time goes quickly. It’s a good idea to structure the sale of property to give maximum flexibility so that the purchase property can be identified prior to the close of escrow. That way if there is some delay there will be time to recover. If you miss the deadlines, your exchange will be disqualified and you will owe the tax.
Sometimes clients are reluctant to sell their property because they don’t know what to invest in. One solution is to find and purchase the investment property you want before you sell. It is still possible to do a 1031 exchange in that case by doing a “reverse exchange.” In other words you acquire the property you want to buy through the intermediary prior to selling your property. Once your property sells then you do an exchange with the property you have acquired through the intermediary. To do this you have to have the money to purchase the property before you sell the property you own. This is rarely done, but for certain wealthy or resourceful individuals it is possible.
In most cases, you will need a broker who has had considerable experience in navigating the exchange process. And, it’s a good idea to consult with a knowledgeable real estate attorney if there are any questions or concerns.
It is also wise to consult with an accountant or financial advisor, however many accountants and financial advisors do not understand real estate exchanges so be prepared to ask lots of questions and make sure the answers deal directly with the tax advantages and disadvantages of doing a tax-deferred exchange.
J. Robert Taylor, J. D., a real estate attorney and broker for more than 20 years, has served as an expert witness and mediator and is on the judicial arbitration panel for Santa Clara County Superior Court. Send questions to Taylor c/o Palo Alto Weekly, P.O. Box 1610, Palo Alto, CA, or via e-mail at firstname.lastname@example.org.
This post originally appeared in the Palo Alto Weekly Real Estate Section.