Capital Gains Taxes…Think Again
A 1031 like-kind exchange puts Uncle Sam on hold

Alison Marek
California Real Estate
Sept. 2005

If you have business or investment property that you’d like to sell and you’re planning to purchase another investment property, think twice … and then call your REALTOR®. A knowledgeable REALTOR® can show you how to defer capital gains taxes by using what’s called a 1031 like-kind exchange, while simultaneously acquiring a replacement property that may be even more valuable than the one you’re relinquishing.

The 1031 exchange (also referred to as a “Starker exchange”) gets its name from section 1031 of the United States Internal Revenue Code, which allows capital gains taxes on an investment asset to be deferred if the asset is traded for one of “like-kind.” And what, exactly, are assets of “like-kind”? Like-kind simply means that they’re of the same nature or character. All real estate is considered to of like-kind, even if one parcel is an undeveloped plot and the other is a newly built retail complex. The money that you save by not paying taxes today may even be used to purchase a higher-priced and more valuable property than you might otherwise have considered. You don’t actually pay the capital gains tax until you sell the replacement or like-kind property.

A 1031 exchange doesn’t need to be limited to a single property, either. With the proper guidance, you may be able to trade one property for two, or even swap multiple properties in what is known as a “multi-asset exchange.” A REALTOR® qualified to handle 1031 exchanges can help you determine what typed of property can be exchanged for the one you currently own. One stipulation is that all real estate involved in the exchange exists within the United States. Another is that all properties involved are solely for business or investment purposes and do not serve as the owner’s primary residence.

Luckily, California residents don’t have to worry about some tricky state tax code gumming up the works. The State handles 1031 exchanges exactly as the Fed does.

Simple as the concept is, the 1031 exchange is also laced with pitfalls, which is why having professional guidance is imperative. Strict guidelines govern when the properties can be exchanged and how the exchange will be reported to the IRS. Once you relinquish your property to the new owner, for instance, you have just 45 days in which to either: 1) take possession of the new property, or 2) create a legal document that lays out the terms of the exchange, identifies each property by its official name, and is signed by the parties involved. In either case, all exchanged properties must be officially closed within 180 days or the tax benefit may be disallowed. Making sure that everything takes place within the time restraints can be tricky – especially when a multi-asset exchange is involved!

In 2005, 120-day extensions for the filing dates will be available to parties in a like-kind exchange if their properties fall within a region designated for federal disaster relief. Even so, there are restrictions on who may be eligible, so counsel is advised.

Despite the red tape, the benefits of a 1031 exchange are well worth the time and effort. Your REALTOR® can even help you come up with some creative ideas to roll the perks of a 1031 exchange into other aspects of your life. For instance, you might be able to buy a rental property in a place where you’d like to vacation; or purchase a condominium complex that can generate income, or a factory that could manufacture the goods you’re currently paying someone else to produce. The possibilities are almost limitless.

So don’t hit the online ads to see what’s for sale. Get your REALTOR® on the phone and start talking about how a 1031 exchange could be the right choice for you.