The 26 U.S. Code § 1031—“Exchange of Real Property Held for Productive Use or Investment”—can help defer payment on taxes generated from your real estate sale. As long as you stay with the IRS’ guidelines and direct the gains of that sale into a like-kind replacement property, you can postpone payment of capital gains and depreciation recapture taxes.
But, is it possible to use the 1031 exchange on short-term capital gains? The basic answer is yes. However, specific issues require consideration if you’re thinking about doing this.
Short-Term Capital Gains—An Explanation
Capital gains are the amount you receive if you sell real estate at a higher cost than what you paid. This definition goes further, defining types of capital gains as follows:
- Short term. Short-term capital gains are realized when you sell a property after owning it for one year or less. In this case, gains are treated as ordinary income and are taxed at your nominal income tax rate.
- Long term. Long-term capital gains are realized when you sell a property after owning it for over a year. The amount you earn from the sale is subject to a capital gains rate ranging from 0% to 20%, depending on your income tax bracket.
Intention Matters
While the IRS doesn’t expressly state how long you must hold a property for it to be eligible for a like-kind exchange, one rule of thumb suggestion is two years. This, of course, contradicts the definition of short-term capital gains.
Another rule of thumb in keeping with IRS requirements is that of intention. In other words, if you can prove that the property you want to sell was meant as an investment, the IRS might be less likely to void the transaction.
What might raise a red flag with the IRS is if you bought a property, renovated it, and flipped it for a profit. This would be considered inventory, part of your trade or business, and ineligible for a 1031 exchange.
Increased IRS Scrutiny
The longer you hold an investment property, the less likely it might come to the IRS’ attention if you’re involved with a 1031 exchange. But if you hold your property for less than a year and then use it as a relinquished property for a like-kind exchange, the IRS might have some questions.
Be sure you have plenty of documentation indicating that the relinquished property was meant as an investment. Proving this in writing could allow you to take advantage of potential tax deferral benefits.
Furthermore, short-term holds as part of a like-kind exchange might be subject to heightened scrutiny, so partner with trusted attorneys, tax advisors, and professionals to help you with the process. These experts can help guide you if challenges and questions arise.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
