Using a 1031 Exchange to Sell Your Rental Property

To accomplish this, selling your property using a 1031 "like-kind" exchange could be just what the doctor ordered, and it'll also keep Uncle Sam happy at the same time. Lets take a look at what a 1031 like-kind exchange is and how it can be used to defer capital gain taxes and build your estate…

The 1031 Like-Kind Exchange

A 1031 or "like-kind" exchange consists of a method for selling your rental property and transferring the proceeds into the purchase of a new rental property without paying tax on the sale. A 1031 exchange, also called a "Starker exchange", is named after its corresponding section of the IRS tax code.

If you complete a 1031 like-kind exchange correctly, you will not owe any capital gains tax on the rental property sold, known as the "relinquished" property. This is because the "tax basis" of the relinquished property becomes the new tax basis of the "replacement" property. It is important to note that a 1031 exchange does not "eliminate" the payment of capital gains taxes, it merely defers payment of those taxes.

When the replacement property is ultimately sold (with no other 1031 exchange performed), then the entire capital gains tax will be due. However, if you still own the property when you die, it will pass on to your heirs. They will not be responsible for paying the deferred capital gains tax on the property because they'll receive the property at a stepped-up basis that is equal to its market value at the time you die.

The rationale behind the 1031 like-kind exchange is to encourage investors to upgrade their investment property by using money that would otherwise be paid out to the IRS as capital gains tax. A 1031 exchange can reduce or eliminate your taxes on the sale of rental property and give you significantly more money to reinvest in other investment properties.

There are two kinds of 1031 exchanges:

• Forward Exchange - With this type of exchange, you first sell your existing property (the relinquished property) and then purchase the replacement property by following the exchange guidelines.
• Reverse Exchange - This kind of exchange consists of first finding a desirable replacement property before selling the relinquished property. The rules for this type of exchange are more complicated than a forward exchange.

To complete a 1031 like-kind exchange, the rules are complicated so you should seek the help of an exchange professional such as an attorney who is a qualified 1031 exchange intermediary.

Here are some of the basic rules for 1031 exchanges:

• The exchanged properties must be "like-kind" which has very broad implications. A single-family house that is held for investment can be exchanged for vacant land, an apartment building for a warehouse, a condo unit for a commercial building, etc.
• The proceeds from the sale of your property must be used to purchase a new "like-kind" replacement property. Any money taken out from the sale will be taxable in the year the property is sold.
• Both the relinquished property and the replacement property must be held for investment purposes.
• The purchase price of the replacement property must be at least equal to the sales price of the relinquished property. If it is not, a tax on the price difference will have to be paid. The taxable difference is referred to as "boot".
• You cannot create a 1031 like-kind exchange after the sale of your property; it must be set up before you sell the property.
• Assumption of mortgages should not be considered, on either the relinquished property or the replacement property, because they create complications for an exchange. Consult your tax adviser first.
• The most effective way to complete an exchange is to use an attorney who is a qualified 1031 intermediary. In this manner, the attorney will hold the proceeds from the sale in an escrow account until the new replacement property is purchased.
• The new replacement property must be identified in writing within 45 days after the sales date of your property. A limit or three properties can be identified in writing during this time. This is very important because if a written identification is not made within the 45-day time limit, the proceeds from the sale are taxable and a 1031 exchange cannot take place.
• The new replacement property (or properties) must be purchased within 180 days of the sales date of your relinquished property.
• You'll need professional help with filing your income taxes for the year an exchange is made. IRS Form 8824 (Like Kind Exchanges) will have to be filed with your tax return.

The bottom line is that a 1031 like-kind exchange can be one powerful and beneficial tax deferral method available for real estate investors, but it is complex. To gain its advantages, you must carefully structure your real estate transaction and make sure that you follow the exact rules and regulations of the exchange.

For more in-depth information about how to use a 1031 exchange and its benefits, please visit The Landlord's Library book collection. It's a terrific, one-stop source for practical, comprehensive information on the entire subject of residential landlording.

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