In our article “Fourteen Ways to Avoid Paying Capital Gains Tax“, we wrote about 1031 like-kind exchanges as a powerful tax-minimization tool for investors and business owners. We said:

If you sell rental or investment property, you can avoid capital gains and depreciation recapture taxes by rolling the proceeds of your sale into a similar type of investment within 180 days. This like-kind exchange is called a 1031 exchange after the relevant section of the tax code.

Despite their complexity, these exchanges have the potential to save vast amounts of money.

The simplistic explanation of a 1031 exchange is this: you negotiate the sale of your property and transfer ownership to a “Qualified Intermediary,” a professional position just for these exchanges. That Intermediary sells the property and receives the proceeds, which they hold on your behalf. You then identify new properties and negotiate a purchase. The Intermediary makes the purchase with the proceeds they held for you and transfer ownership of the new property to you.

Thus, via the 1031 exchange, the capital gains and recapture taxes you would have otherwise owed from the sale of the first property are deferred until you sell the new property.

This can also be done in reverse (acquiring new property before selling the old), but the process is more complex.

These nine extra rules must be minded when undergoing this type of exchange:

First, any property involved in a 1031 exchange must be used for business or investment. You cannot sell or receive a home, land under development, or property purchased for resale. Secondary and vacation homes can sometimes qualify as investments, but only if its personal use is very limited.

Second, property received must be of “like kind” to the property sold. For real estate, nearly everything is of like kind; undeveloped land is of like kind to apartment buildings and corporate offices.

Third, the Intermediary is a necessary legal buffer because if you receive any money before the exchange is completely finished, the tax-deferred treatment of gain is broken and all taxes become immediately due.

Fourth, Qualified Intermediaries are their own specific brand of professionals, not just due to the complexity of 1031 exchanges, but because you are not allowed to act as your own Intermediary, nor designate anybody else who has acted as your “agent” in the past two years, including real estate agents, investment brokers, accountants, attorneys, and employees.

Fifth, from the day the property is sold, you have 45 calendar days to find potential new properties and 180 to complete the exchange. These windows are strict. They count holidays and weekends, cannot be extended, and run concurrently.

Sixth, “identification” must be made in writing, clearly describing the new properties, and must be delivered to and signed by the Intermediary or current owner of the new property.

You may identify more than one replacement property, up to a maximum of three, with no regard as to their fair market value. Identifying more properties gives you a hedge in case the potential seller decides not to go through with the exchange after all, leaving you with a pile of capital gains tax to recognize.

Or, you may identify any number of replacement properties so long as their combined fair market value does not exceed 200% of the value of the property you sold.

Seventh, it is best to purchase a new property of equal or greater value to the one you sold because any funds left over at the end or additional property received with the new real estate are counted as “boot” and immediately taxed as capital gains.

The exchange is complete when the Intermediary transfers the newly acquired property back to you along with any boot (leftover funds or additional property acquired). Thankfully, despite the fact that boot and net gain from the exchange are taxed immediately, they do not void the deferral of capital gain and recapture taxes that were rolled into the new property.

Eighth, the cost basis for the new property is equal to the basis of the old property. The new basis is decreased by the amount of any boot received, then increased by any gain taxed during the exchange.

Ninth and finally, be careful engaging in this kind of transaction with family members because the tax-deferred gains can be forced into recognition if, in an exchange between related parties, either party sells their property before two years pass.

While 1031 exchanges are usually used for real estate, you can also exchange personal property used for business or investment (except for stocks, bonds, inventory, debt, and partnership interests). However, the rules governing what is of like kind are quite restrictive.

The most advantageous use of the 1031 exchange rules is to keep exchanging the acquired property. The deferred taxes will roll into that property to be recognized on its sale. If this is maintained long enough and the last acquired property is passed on to heirs, it will receive a step up in cost basis, at which point the taxes due effectively vanish.

All told, a 1031 exchange is tricky to manage but definitely worth investigating.

Photo used here under Flickr Creative Commons.