Utilizing a 1031 Exchange to Avoid Capital Gains Taxes

If you are planning to leave an investment property to loved ones, a 1031 exchange may be a helpful estate planning tool for you.

Because these exchanges allow you to defer taxes or limit taxes owed at the time of a sale, you can use the money that would have been spent on taxes to increase your real estate portfolio, rental income, and personal wealth.

What Is a 1031 Exchange?

A 1031 exchange is a process in which you exchange one investment or business property for another, thus deferring capital gains taxes on any profits you make from selling the first investment property. Although you do not avoid capital gains, you can push a significant portion of capital gains taxes owed into the future. However, you must follow specific rules for a sale and purchase to qualify as a 1031 exchange.

How Does a 1031 Exchange Work?: Three Requirements

A 1031 exchange will be recognized by the Internal Revenue Service as long as the transaction meets specific criteria:

1. The main requirement is that the exchanged properties are both investment properties, regardless of whether they were the same type of property (for example, an apartment, a building, a multifamily, et cetera). There are also special rules when it comes to vacation homes.

2. Second, money from the sale of the first property must be held by a “qualified intermediary” until the second property is ready to be purchased. A qualified intermediary is a third party that escrows funds until a new property is ready for purchase. You cannot receive funds at any point in the sale of the first property and subsequent purchase of an exchange property. Thus, it is crucial to use a trustworthy and reputable company.

3. Third, the exchange needs to happen within a specific timeframe. You must designate, in writing to the intermediary, properties you’re interested in buying within 45 days of the sale of your first investment property. You then have 180 days to complete the purchase of the exchanged property.

The 1031 exchange process can be done back-to-back without limit on the number of transactions, as long as they are all done correctly. This means that many people can defer capital taxes for very long periods.

When you ultimately decide to sell your exchanged property for cash, you’ll pay taxes at the long-term capital gains rate. That can be much less than other tax rates. For example, in 2022, the tax rate is 0 percent, 15 percent, or 20 percent, depending on a person’s taxable income.

1031 Exchanges and Estate Planning

You may not realize that 1031 exchanges can be a valuable estate planning tool. For example, if you pass away without ever selling your replacement property, your heirs will inherit it at market value. Your loved ones won’t have to pay capital gains taxes on any property value appreciation.

Before determining whether a 1031 exchange is suitable for you, you must consider additional intricacies and rules. If you are considering a 1031 exchange as part of your estate planning process, it is a good idea to speak with an attorney in your area.