In California and other states, if you plan on selling a business or investment property and have already identified a replacement property, the Internal Revenue Service (IRS) allows you to defer capital gains from the sale using a like-kind or Internal Revenue Code 1031 exchange.
With this method, instead of using some of the sale proceeds to pay taxes on your profits, you can use the money to purchase a new property, as long as it is of “like-kind.” The rules and restrictions surrounding 1031 exchanges are complex, although the following can shed some light on the overall process.
Identify your purchase target
Identify potential properties to purchase before you sell your existing property. According to tax law, you must ensure the new property is like-kind, which generally speaking means you must purchase it for productive use in your business or trade, like the property you want to sell. For an example of non-qualifying assets, you may not trade business or investment properties for a personal residence or property in a foreign country because they are not like-kind.
Understand the 1031 exchange rules
The IRS has several rules and regulations to comply with so that your 1031 exchange qualifies. For example, the process involves deadlines without hardship or exclusion if you miss them.
If you do not adhere to all the rules, you may lose the tax-deferred status for your real estate transaction and end up owing taxes on the gain from your property sale.
When entering a 1031 exchange transaction, you must use a neutral third party to facilitate the exchange. This party, called a qualified intermediary, helps you navigate and comply with complex rules, and handles the exchange of funds between the properties, among other tasks. Your qualified intermediary cannot be any agent, such as an accountant, attorney or real estate agent, who has worked with you within the previous two years.
Why use a 1031 exchange?
Aside from deferring taxes on capital gains, there are several other reasons to utilize this tax strategy. Suppose you want to find a property with better appreciation prospects or diversify your assets. As a property investor, you may want to consolidate your property portfolio to fewer properties or diversify ownership of one larger property into several smaller assets. You can also reset the depreciable value of your investment property through a like-kind exchange transaction.
Understanding how a 1031 exchange works can help you use this tax strategy to reduce your liability.