Defer the Pains of Capital Gains: A 1031 Exchange Primer

A 1031 exchange can help protect your capital when you’re buying and selling investment properties.

A 1031 exchange can help protect your capital when you’re buying and selling investment properties.

From the letter bag: Hi Kim, Your column about concurrent closings reminded me of some trouble I had a few years ago. I sold my second house to invest in an apartment building and got hit with a big tax bill, even though the new property cost more. Now I’m looking at new properties again, but I need to do some research to avoid another unexpected tax penalty. Where should I start?

Signed — Serial Investor

Dear Serial

Ouch! Before you take another step, repeat after me: “1031 Exchange” (pronounced ten-thirty-one exchange). Now get used to saying this to your tax advisor and REALTOR® every time you even think about future investments; they need to know that’s what you’re up to, and they’ll know how to help you. There’s not quite enough space here for all the rules and caveats, but we’ll take a quick look at the most important stuff.

First up, what feels like a “penalty” is actually normal capital gains tax resulting from the sale of property. But with a little planning (and a little help from your friends), you can defer that tax. A 1031 exchange lets you invest the proceeds from a sold property into another property of like kind (i.e., another real estate investment), which is something investors might do when they’re seeking a better return (like yourself), upgrading to a managed property, consolidating or diversifying investments, or working on any number of other goals.

Sellers can be surprised to find their capital gains tax is so high, especially if they’ve sold their property for around what they originally paid. This happens because the gains are calculated by pitting the sales price against the property’s original price, plus improvements, minus depreciation — and that depreciation’s where they getcha.

Deferring your capital gains tax offers many benefits, chief among them the ability to use that rescued capital toward the new investment. Many transaction expenses and fees can be paid with exchange funds, lowering future tax burdens. Paired with judicious estate planning, a 1031 exchange can benefit future heirs, whose inherited property will be cleared of the tax deferment debt.

Before listing your current property or searching for your next, you must prepare the legal structure for the exchange. This is where the “help from your friends” comes in — you must move the sale proceeds into your next purchase through a qualified intermediary. Think of it like a magic escrow, shielding those funds with a cloaking spell so your touch doesn’t wake the sleeping tax monster. (Can you tell I’m answering your question right after Comic-Con?)

Once you’ve sold your first property, you must identify its replacement within 45 days and close on it within 180 days. Ideally, that next property will be of equal or greater value (or the difference will wake the tax monster). If the new place is not as intrinsically valuable, you can make improvements in a build-to-suit exchange, but that also must be completed within the 180 days. In what’s called a reverse exchange, you can close on the replacement property before selling the original, but in that case the title to the new property also has to move through a qualified intermediary.

And that’s just the tip of the iceberg. BUT, it’s a really valuable iceberg, so don’t let the complexity scare you off!

The short answer to your original question: Read up on 1031 exchanges, and don’t try to wing this one. Work with a good CPA and sit down with a REALTOR® with solid investment property experience. Since that’s one of my specialties, I welcome you to give me a call to chat anytime. Thanks for the great question, Serial Investor.

Do YOU have a question about real estate? Get in touch with me, no obligation ... although I might ask to use your question in a future column or blog post!