With appreciated shares, you can sell your shares over several years to spread the appreciation. Unfortunately, investment property does not enjoy the same luxury; the full amount of the gain must be claimed on your taxes in the year the property is sold, unless certain steps are taken to minimize this risk. If an investor uses IRS Section 1031 to recognize a “like-kind” exchange when selling an investment property, capital gains may be deferred by purchasing a similar investment property.

Sale date management

You can mitigate this tax burden by controlling the year in which you lose title and possession and, therefore, the year in which you report the capital gain on the transaction. In other words, you can set the transfer of ownership to a year in which you expect to have a lower tax burden.

According to the Internal Revenue Service (IRS), “part or all of the net capital gain may be taxed at 0% if your taxable income is less than $80,000”. So if you have no active income and minimal passive income, including the gain on the sale of your investment property, you could avoid paying taxes on your minimum capital gain. However, if your income is stable and paying tax on the gain seems unavoidable, you may consider using the IRC Section 1031 exchange.

Section 1031 Exchange

The IRS Code Section 1031 exchange allows an investor to exchange real estate held for investment purposes for other investment real estate and does not incur any immediate tax liability. Under Section 1031, if you exchange a business or investment property only for a business or investment property of the same nature, no gain or loss is recognized until the newly acquired property is sold. .

As of 2018, the Tax Cuts and Jobs Act limited similar exchanges to real estate. Exchanges of personal property, such as works of art, under Section 1031 are no longer permitted. 

Rules and Regulations

IRS Code Section 1031 will not avoid capital gains taxes in all cases. For example, the exchange of US real estate for real estate in another country will not qualify for tax-deferred exchange status. Additionally, trades involving property used for personal purposes, such as exchanging a personal residence for a rental property, will not receive tax-deferred treatment. Finally, if an exchange is made between related parties and either party subsequently disposes of the exchanged property within two years, the exchanged property will become subject to tax. 

For tax reporting purposes, the basis of the old property is carried over to the new property. This is important to understand because the taxes due are not remitted, they are simply deferred until the sale of the new property.  To register the Section 1031 exchange with the Internal Revenue Service, it is important to file Form 8824 with the tax return for the year of the like-kind exchange, as well as for each of the following two years the exchange. 

Section 1031 and Losses

A tax-deferred exchange is also possible if you sell your investment property at a loss. First, you need to determine if the loss is a “tax loss” or just a personal loss. In order to qualify as a tax loss, your adjusted basis in the property must be greater than the selling price of the property. Your adjusted basis takes into account any previous depreciation deductions you took (or were allowed but did not take).

For example, suppose you purchased a rental property for $400,000. Over the past ten years, you’ve taken $100,000 in depreciation on the building. Your current adjusted base is $300,000. If you sell your rental property for $350,000, it may seem like a loss, but it’s actually a gain of $50,000 for tax purposes. The gain is considered an unrecovered item 1250 gain and is taxed at a rate of 25%. However, you could buy a “similar” property to avoid paying taxes immediately on your $50,000 gain.

Alternatively, suppose you sell the same house for $250,000. This is a tax loss of $50,000, plus a personal loss. Is there still an advantage to a “like-kind” exchange? Maybe. If you buy a “similar” property for $250,000, your base in that second property will immediately be $300,000 (your adjusted base in the first property). This would benefit you when it comes time to sell the second property, as the basis on which you take capital cost allowances is higher.

Fully tax-deferred exchange

For a tax-deferred Section 1031 exchange transaction to occur, certain conditions must be met:

• The property must be “like-kind”: Goods are of the same nature if they are of the same nature or character, even if they differ in degree or quality.
• Ownership must be related to a business or investment: The goods exchanged must be held for commercial or investment purposes and exchanged for the same use. For example, a traded good should not be held primarily for resale.
• The new property must be identified within 45 days: The new property to be received in exchange for an existing property must be identified in writing, to the seller, within 45 days of the first assignment.
• The transfer must take place within the 180-day window: Like-kind property must be received on one of two dates (whichever comes first): within 180 days of the transfer of ownership, or on the tax return due date (including extensions) for the year in which ownership is transferred. 

Partially tax-deferred exchange

To be fully tax-deferred, the exchange must be only an exchange of goods of the same kind. In a perfect world, finding a property with the same business value is ideal for Section 1031 exchange. However, finding an equal exchange is difficult and in many cases one party ends up paying the money. extra to make the deal fair. This additional property or money received is known as a “boot”, and this gain is taxed up to the amount of the boot received.

When there are mortgages on both properties, the mortgages are offset. The party that waives the larger mortgage and receives the smaller mortgage treats the excess like a boot. 

The essential

The increase in the number of real estate sales has allowed many people to benefit from favorable tax treatment from the federal government. As a result, a huge amount of tax revenue was lost. For now, Section 1031 exchanges for real estate remain. (As noted above, as of 2018 they have been eliminated for other types of property, such as collectibles, aircraft, franchise rights, and heavy equipment.)As always, discuss your plans with a tax professional if you have a rental property you are considering selling to find out what rules apply to your situation.