How to Legally Defer Capital Gains Tax on Your Property Sales
According to the National Association of Realtors, median home price sales were up 16.9% in 2021, the highest on record since 1999. There’s no doubt in anyone’s mind that the housing market is hot and, like a lot of investors, you might be interested in selling your property and earning those sky-high profits. But when I talk to other investors, the same concern always comes up: What’s the best way to legally avoid capital gains tax when that day comes?
See, when you sell your shares of stock at a profit, you’ll get hit with capital gains tax. But real estate investors can sidestep this bill completely and, if done correctly, in perpetuity.
Enter the Like-Kind Exchange, which is under section 1031 of the Internal Revenue Code.
Commonly known as a “1031 exchange,” this vehicle allows us to defer taxes from a recent sale when we purchase another similar (or like) property. Theoretically, these taxes could be deferred forever, which we’ll get to later.
Here are some rules and key points to understand if you’re an investor looking to sell property and avoid capital gains tax using this strategy.
How It Works
Let’s say you purchased a single-family investment home for $100,000. Let’s call that Property A. It appreciates to $250,000, netting you a profit of $150,000. Because you’re a savvy investor and know the benefits of a 1031 exchange, you can turn around, take that profit of $150,000 and purchase new property. Let’s call this Property B.
The good news is, while there are requirements that must be met to qualify the new property as “like,” the rules aren’t as strict as you might think. Properties A and B must be used for business, investment or trade, but selling office space for a residential property, for example, still qualifies under section 1031. A no-no would be selling a single-family home and buying an oil well.
To undertake a 1031 exchange successfully, you’ll need to move within a set time frame.
- First, you’ll have 45 days from the sale of your property to identify the new one you’ll replace it with, in writing.
- Second, you’ll have 180 days from the date of the sale to close on your replacement property.
How it’s Legal
You might be thinking: This is too good to be true, how is this legal? Let me put your mind at ease. Section 1031 has been around since 1921! The law is over 100 years old with plenty of case law to support its use.
But that doesn’t mean it’s not a hard row to hoe. You must follow the process to a T—there is no room for error. I know, because I failed the very first time I tried.
One way to reduce potential mistakes is to hire someone to help. Once you sell your property, it’s important that you do not touch the money before the exchange is complete. This will be a disqualifier, making any gains immediately taxable.
The best way to avoid complications is to go through a qualified intermediary—someone to hold the cash until the transaction is complete. There are rules around who qualifies for this, too. If you’re looking for a qualified intermediary, check out my chat with Bill Exeter in Episode 20.
How You Do it in Perpetuity
There’s a way to avoid capital gains taxes forever, but there’s a catch: you’d have to, you know, bite the dust. If you want to pass down property to children or other heirs, you can do so tax free because the cost basis resets to the current market value.
If you purchased Property B for $500,000 but it appreciated to $1 million by the time you died, your heirs wouldn’t be taxed that $500,000 profit. Instead, the new cost basis on the property will be $1 million.
Disclaimer: I’m not a CPA. I’m not a lawyer. I’m just a guy on the internet sharing what I know to help my fellow investors. Don’t just believe what you read on the internet—ALWAYS consult with your legal and financial advisors before
If you would like to learn more about the ins and out of the incredible benefits of 1031 exchanges, head over to Episode 20, which I also mentioned above.
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