Typically, when you sell an investment property, you must pay capital gains tax on any profit you earn from the sale. To give you a quick example, if you buy an investment property for $200,000 and sell it for $300,000, you have $100,000 in profit, and you may owe capital gains on that amount.
Looking for a way to defer capital gains on an investment property? Then, you may want to exchange your property for a similar one. Based on the rules of Section 1031 of the tax code, you don't have to pay capital gains when you exchange properties like this. Before trying a 1031 exchange, keep these rules in mind.
Section 1031 Only Applies to Investment Property
You can only use Section 1031 for investment properties. You cannot exchange vacation homes with another party or trade your primary residence. This rule only applies to properties owned for the intent of earning a profit.
The Properties Do Not Have to Be Identical
Although the tax code says that properties exchanged under Section 1031 need to be like-kind, they do not have to be identical. Both of the properties must be investment properties, but in most cases, that's the only similarity you need to take into account.
For instance, you could swap an apartment building for a vacant lot or a duplex for a medical clinic. Again, as long as both properties are investment properties, you can take advantage of the Section 1031 capital gains deferral.
The Swap Doesn't Have to Be Immediate
You don't have to do the exchange on the same day. Instead, you have 45 days from the day you sell your investment property to acquire a like-kind property, and you have 180 days to actually close on the second property.
To take advantage of this extra time, you cannot receive the funds from the sale of your investment property. The funds must go to a third party. They hold onto the funds until you're ready to buy the next property, and then, they dispatch the funds to the owner of that property.
You Can Face Capital Gains for Reducing Your Debt
If there is any change from the sale, you may face capital gains on that amount. To give you an example, imagine you exchange a $250,000 property for a $200,000 property, and you receive $50,000 in change — you may have to pay capital gains on the $50,000.
However, you don't just face possible capital gains on change from the sale. You may also face capital gains if you reduce your debt. To stay with the numbers above, imagine you owed $250,000 on a property and you exchanged it for a property with a $200,000 mortgage. Because you have reduced your debt by $50,000, you may face capital gains on that amount, even if you don't have it in cash.
For more information about rental property 1031 tax exchanges, contact a local law office.
