The 1031 Exchange: how to defer taxes when selling real estate

As a general rule, if you sell a real estate property in the United States you will likely trigger a taxable transaction.  However, if you complete the sale through a 1031 exchange, you will sell your property without incurring an immediate tax liability and you will utilize the money you would have paid to the IRS in taxes, to increase your overall buying power to acquire a more valuable property.

How is the capital gain calculated?

If you sell property for a higher price than you purchased it, you realize a
capital gain. You can deduct from your gain the selling expenses (such as the real estate agent commission and the title agent fees) as well as any improvement (such as upgrading the kitchen or re-tiling the bathroom).

What are the capital gain tax rates?

If after the above deductions, you have a positive gain, it will be subject to the capital gain tax rates. If you held the property less than one year, your gain will be taxed at the ordinary income tax rates (7 brackets from 10% to 37%). If you held the property more than one year, your gain will be taxed at the
lower long-term capital gain tax rate (0%, 15%, 20%).

Read more on the rates:

How does 1031 exchange work?

Under IRC §1031, a capital gain taxation is differed if a property is sold and the funds are reinvested to buy another property. To qualify the transaction must meet the following criteria:

The property was held for investment: the property traded and the property received must be held for productive use in the taxpayer’s trade or business or for investment purpose (such as a rental property). The following property do not qualify: real property used for personal purpose (such as a home, vacation home), property held for resale (such as inventory), partnership interest, any personal of intangible property.

The second property purchased is of the same nature as the property sold (like kind property): property must be of the same nature or character, even if they differ in grade or quality (such as if one is improved and the other one is not). The following properties do not qualify: a real property in the United states and a real property outside the United States.

The transaction is completed during the qualifying period: the second property purchased is identified within 45 days of the sale of the first property AND the second property purchased is acquired within 180 days of the first property sold.

The transaction is completed by a qualified intermediary: the transaction must be completed by a 1031 exchanger and the proceeds from the sale of the first property must be held in escrow by the exchanger to purchase the second property.

The tax advantages of a 1031 exchange

With a 1031 exchange, the capital gain of the sale of the first property is differed until the second property is sold. A tax return must still be filed the year of the sale of the first property to inform the administration that a 1031 exchange has been completed. In addition, with a 1031 exchange, as there is gain recognized, there is no
FIRPTA withholding if the seller is foreign.

Read more on FIRPTA withholding:

As always in tax law, there are exceptions to the general rules, so make sure you contact your tax professional
Karine Bauer, EA for tax answers specific to your tax situation.  The views contained in this article are not tax or legal advice and are not a substitute for consulting with a tax professional. Karine Bauer, EA is an Enrolled Agent licensed by the Treasury Department with unlimited rights to represent taxpayers before the Internal Revenue Service. She is an experienced tax professional with more than 20 years of international experience.

Bear in mind the date of this article as tax laws evolve over time

Published March 14th, 2020