“The dirt has to make sense” and “the money is made on the buy” are two well-known truisms when it comes to consistent wealth generation from real estate ownership — with one important caveat: when properties are eventually sold, the resultant capital gains tax can significantly cut into a real estate owner’s profit margin.
Luckily, this capital gains tax can be avoided by using a tax deferral strategy known as the Like-Kind Exchange.
The IRS created the like-kind exchange under Section 1031 of the Internal Revenue Code after realizing that imposing a capital gains tax on every property sale created a strong disincentive to economic growth. Soon thereafter, the most astute real estate owners decided that under certain circumstances, it might pay to take their real estate with them “to the grave.”
As a result, the “Defer, Defer, Die!” game plan was born (no pun intended).
Understanding the Like-Kind Exchange
A Section 1031 exchange involves the selling of one property, called the relinquished property, and the buying of another, called the replacement property. Like-kind exchanges require the use of an external third-party called the qualified intermediary (QI), or accommodator, who manages transactions by keeping them compliant with IRS regulations.
There are four primary types of Section 1031 exchanges:
- Simultaneous: The sale of the relinquished property and the acquisition of the replacement property must occur on the same day.
- Forward: The owner first sells the relinquished property, then later acquires the replacement property. Following the initial sale, the QI transfers all proceeds to a binding trust, after which time the owner has a 45-day identification period to submit a written list of possible replacement properties to the QI. The owner then has an additional 135-day purchase period to buy one of the replacement properties, the purchase of which is executed by the QI. The collective window of time for the entire process encompassing the identification and purchase periods is known as the 180-day exchange period.
- Reverse: The replacement property is bought before the relinquished property is sold. To qualify as a 1031 exchange, the QI must manage the acquisition of the replacement property and then transfer it to the exchanger/owner only after the exchange is finalized. This is accomplished by creating a single-member LLC called an exchange accommodation titleholder (EAT).
- Improvement/Construction: After selling the relinquished property, the owner selects a replacement property valued considerably lower. Over the course of the exchange period, the owner manages improvements to the replacement property while it is held by the EAT, which was set up by the QI. At the end of the 180-day exchange period, the property must be sufficiently improved to qualify as a like-kind exchange.
Before & After: The Impact of the Tax Cuts and Jobs Act of 2017 (TCJA) on 1031 Exchanges
Savvy participants, owning a wide variety of asset classes, have used like-kind exchanges for decades since first authorized in 1921. Before the passage of the TCJA in 2017, a wide range of assets including machinery, livestock, artwork, aircraft, musical instruments, and cryptocurrencies were eligible for like-kind exchanges.
Under the new tax law, only real estate like-kind exchanges are permitted, and the definition of like-kind is very broad. Thus, nearly any two properties — a vacant tract of land and a log cabin, for example — can be exchanged as like-kind if they are of comparable value and are either rental, investment, or business properties.
Tax Deferral Is Good. A Complete Shield From Liability is Better
Here is where the morbid, yet pragmatic, saying “Defer, Defer, Die!” comes into play. Think of the 1031 exchange as a sort of tax-free loan, courtesy of the government. Individuals, businesses, and investors who own real estate can continue to accumulate the appreciated principal by rolling forward the gains using repetitive exchanges, and in the end, may never have to pay a penny in capital gains tax.
A like-kind exchange permits the deferral of capital gains when swapping out one business or investment property for another, for as long as the replacement property is owned. If a real estate owner opts to sell the 1031 replacement property, it can be exchanged for another property, and both the original and subsequent capital gains can continue to be deferred.
There is no cap on the number of exchanges that can be transacted in this manner. If an owner decides to sell without exchanging again, the capital gains tax would come due. If the owner exchanges and trades down in property value or equity, tax will only be applicable to the amount of the trade-down. But what happens if an owner never sells the property outright and consistently initiates ongoing like-kind transfers, thus deferring the gains tax indefinitely?
When a property owner dies, their assets are passed on to surviving heirs at a stepped-up basis. This means the beneficiaries will acquire the property at a basis equal to the fair market value at the date of death (or the alternative valuation date), not at the decedent’s adjusted tax basis. In doing so, all of the capital gains that were deferred over the owner’s lifetime are completely forgiven. The recipients can immediately sell the property without being liable for any capital gains tax.
Successful Real Estate Investors Use Like-Kind Exchanges to Their Advantage
When implemented properly, Section 1031 exchanges are an exquisite tax deferment tool. Following the passage of the new tax law, real estate is the only remaining asset class that qualifies for capital gains tax postponement — and the accompanying complete avoidance in certain circumstances — making real estate the winning choice for long-term wealth accumulation.
This article is not tax, legal, or other professional advice and cannot be relied upon for any purpose without consultation and advice from a retained professional.
As one of the most knowledgeable and well-connected tax & accounting professionals in the world, Harvey Bezozi's mission as a CPA and CFP ® is to provide concierge-level work product and service, along with seamless communication, high energy, and a super-positive attitude. Located in Boca Raton, Florida, Bezozi has been in business since 1994, and serves clients in all 50 states and internationally. More information can be found at YourFinancialWizard.com
© 2023 Newsmax Finance. All rights reserved.