Q: Marsha, I own a single-family residence that has been a rental for many years. I purchased the house for $100,000, and I think I can sell for about $950,000. I’ve heard about “1031 exchanges” for income property. Can that help me avoid paying taxes? How does it work?
A: I can explain the basic concept of an IRS 1031 exchange, but if you move forward with the exchange, promise me you’ll contact your CPA.
An IRS 1031 exchange is a trade of like-kind investment properties that allows you to defer capital gains taxes on your profit. The definition of “like-kind” is broad; you can exchange your rental for land, commercial, or rental properties. You can’t use a 1031 exchange for your personal residence.
The 1031 exchange has three key players: first, you, the exchanger who is relinquishing property; second, the accommodator who facilitates the exchange; and third, the owner of the replacement property you are acquiring. Notice I never said the word “sale.” This is not a sale; it is an exchange of properties. A 1031 exchange is a promise to trade your rental property for another rental property you will identify within a strict time frame.
Here’s how it works: You hire an accommodator and announce to the marketplace you want to exchange your $950,000 rental for like-kind property. You’ll find a replacement property that is the same or greater value than the one you are relinquishing. The 1031 exchange will allow you to defer capital gains taxes on your gain of $850,000. What happens in five years when you want to exchange the replacement property for a new property valued at $2,000,000? You’ll do another 1031 exchange to defer your capital gains of $1,900,000. Your original basis will always be $100,000, the purchase price of the original rental property. To exit the 1031 train, you’ll have to pay taxes on your equity over that $100,000. It’s like the Hotel California: You can check out any time, but you can never leave (with any of your money).
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There are some important concepts to understand concerning 1031 exchanges. For one, you are never allowed access to the equity in the relinquished property. The accommodator will hold the proceeds from the original property in escrow.
Second, it’s important to understand the 1031 exchange time frames. The rules and regulations must be followed and are inflexible. Delays and events may happen that are beyond your control, and there will be no forgiveness or understanding on the part of the IRS.
Once you have closed on the relinquished property and the proceeds are with the accommodator, you have 45 days to identify a replacement property. You have 180 days, again from the close of the relinquished property, in which to exchange into your replacement property.
The 1031 allows you to defer taxes indefinitely, without penalty or interest. It’s up to you, the taxpayer, to decide if the exchange is a valuable real estate tool for you to use.
Marsha Gray, DRE #012102130, NMLS#1982164, has been a real estate broker in Santa Barbara for more than 20 years. She works at Allyn & Associates, real estate services and lending. To read more Q&A articles, visit MarshaGraySBhomes.com. She will research and answer all questions submitted. Contact Marsha at (805) 252-7093 or MarshaGraySB@gmail.com.
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