Real estate investments have been on the rise over the last five years, and investors are increasingly faced with real-estate specific tax issues. With appreciated stock, you can sell your shares over a number of years to spread out the capital gains. Unfortunately, investment real estate is not granted the same luxury; the entire gain amount must be claimed on your taxes in the year the property is sold. In this article, we explain one way to avoid taxes when selling real estate: the Internal Revenue Code Section 1031 exchange.

Dealing with Appreciated Real Estate

One downside of real estate investments is that they are not liquid assets like stocks or bonds. Even in today’s booming market, it can sometimes take more than a year to settle a real estate deal. If you’ve decided to sell your real estate and get out while the getting is good, you may be faced with a hefty tax bill on your gain. You could mitigate this tax burden by controlling the year in which title and possession passes and, therefore, the year in which you report the profit or loss 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. However, if your income is steady and paying tax on the gain looks inevitable, you may want to consider using the IRC Section 1031 exchange. (For further reading, see A Long-Term Mindset Meets Dreaded Capital Gains Tax .)

The 1031 Exchange

The 1031 exchange allows an investor to trade real estate held for investment for other investment real estate and incur no immediate tax liabilities. Under Section 1031, if you exchange business or investment property solely for business or investment property of a like kind. no gain or loss is recognized until the newly acquired property is sold. Keep in mind that Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, evidence of indebtedness and certain other assets.

Fully Tax-Free Exchange

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

Property must be like kind - Properties are like kind if they are of the same nature or character, even if they differ in grade or quality.

Property must be related to business or investment - Exchanged property must be held for productive business or investment use and traded for the same use.

New property must be identified within 45 days - The new property that you intend to receive in exchange for your existing property must be identified in writing within 45 days of the first transfer.

Transfer must take place within the 180-day window - The like-kind property must be received by one of these two dates (whichever comes sooner): within the 180-day period following the property transfer, or by your tax return due date (including extensions) for the year in which you transferred the property.

Let’s look at an example:

Example - A Tax-Free 1031 Exchange

Nate purchased an investment land lot four years ago for $50,000. Today, the fair market value of the land lot is $150,000. Nate is ready to sell the lot, but he is not particularly enthused about paying taxes on the $100,000 gain. He finds a seller, Jill, who has a $150,000 rental property for sale that interests Nate. If Nate and Jill agree to trade their properties, the exchange will be tax free under Section 1031 exchange rules. As an added bonus, Nate may even be able to claim depreciation on the building.