November 2022 – In the world of real estate sales, both residential and commercial, many savvy property owners have utilized a strategy to defer capital gains tax on real property through the use of a “Like Kind” Exchange, or 1031 Exchange (named after Internal Revenue Code Section 1031*). While I am not a tax expert and you should consult your tax professional (CPA or Tax Attorney) before taking any action, the below information is meant to provide the basics of an effective tool to defer taxes and potentially grow equity in real property over time. There are many nuances and important technical aspects of a 1031 exchange that should be discussed thoroughly with your tax professional, or else you may be subject to taxation, penalties or awkward conversations with IRS agents during an audit (nobody wants that!)
A “Like Kind Exchange”, or 1031 exchange, is defined by the IRS as “when you exchange real property used for business or held as an investment solely for other business or investment property that is the same type or “like-kind”. In the case of real estate, properties are of “like kind” if they’re of the same nature and character, even if they differ in grade or quality, regardless of whether they’re improved or unimproved. Almost all real estate qualifies for an exchange, with the exception of one’s primary residence. For example, if one owned a Four-unit multifamily apartment building and wanted to perform a like-kind exchange into an office building, that would be fine.
1031 Exchange Example
To illustrate the basics of a 1031 exchange, a simple example can help show the benefits compared to an after-tax traditional property sale
An investor sells property (with no debt) for $1,000,000. The property has been fully depreciated and has a cost basis of $100,000. The property has been held for >12 months, so long-term capital gains is applicable, and we will assume a combined tax rate of 25% for simplicity (federal capital gain, depreciation recapture, net investment income tax and state).**