Year-End Tax Planning – 1031 Exchange

Investors who are looking to sell real property before the end of the year may want to consider a 1031 exchange – also called a “like-kind” exchange – if they are planning to use the proceeds to invest in another property.

The advantage of entering into a 1031 exchange at the end of the calendar year is that you can get the deferral of federal capital gains taxes for the current tax year even if the exchange is not completed by year’s end. If you end up not finding an appropriate replacement property to complete the exchange in 2020, you have still deferred the a portion or all of the gain into 2020 since you won’t receive the proceeds of the sale until then.

What does a 1031 entail?

A 1031 exchange – named for Internal Revenue Code Section 1031 – enables a taxpayer who owns real property that is used in a trade or business to defer taxes on any gain when the property is sold, as long as the taxpayer identifies another property to acquire, also to be used in a trade or business, within 45 days. The transaction must be complete within 180 days of the sale of the original property. Do not confuse this with qualified opportunity funds.

The tax deferrals available through 1031 exchanges offer several advantages, including:

  • They enable property owners whose investment objectives have changed to sell old properties and acquire new ones without immediate tax expenses.
  • For investors who hold their properties for the long-term, 1031 exchanges can minimize taxes by deferring them to a time when the taxpayer’s income is lower in retirement.

Congress has expanded and contracted the applicability of 1031 exchanges many times over the years, most recently with the Tax Cuts and Jobs Act (TCJA) of 2017. Prior to the TCJA, 1031 exchanges could be applied to transactions involving tangible personal property such as vehicles and heavy equipment, but the TCJA redefined them to apply only to exchanges of real property.

Know the law

It’s important to remember that you cannot carry out a 1031 exchange on your own. By law, if you intend to engage in a 1031 exchange, you must work with an independent intermediary. When you sell your original property, the proceeds from the sale are held by the intermediary until you find a new property to invest in. If you don’t find an appropriate property in which to reinvest the proceeds, the intermediary will release the funds to you, but the gain on the sale will be recognized and subject to tax on the gain at that point. Moreover, you still will have to pay the intermediary’s fees.

Next Steps

If you intend to engage in a 1031 exchange, involve your advisors, especially your accountant, early in the process to make sure the exchange is appropriate to your situation.

And if you plan to start the process before the end of this calendar year, it’s time to get moving.

Contact us if you would like to discuss a 1031 exchange.

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