According to Benjamin Franklin, the only thing certain is death and taxes. And, when it comes to owning real estate as an investment, taxes are definitely certain. In addition to property taxes and taxes on earned income, capital gains taxes must be paid when the asset is sold (assuming, of course, that it is sold at a profit).
On the positive side, tools are available to help mitigate some of these capital gains taxes. One of these is found in Internal Revenue 26 U.S. Code § 1031: “Exchange of Real Property Held for Productive Use or Investment.” Better known as the 1031 exchange, the process can help defer capital gains taxes through a form of property swap.
The structure of the 1031 exchange means that you could continue trading into various properties of equal or greater value for a long time. But does doing so decrease your tax liability?
The answer here is no. The 1031 exchange program is a tax deferral tool. It doesn’t eliminate or decrease taxes in any way. Let’s take a closer look at this issue.
Understanding Tax Liability
In its most basic sense, tax liability is a fancy term for “how much you owe in taxes to taxing authorities.” You are taxed on earned income, capital gains on the sale of a capital asset, or other IRS-defined taxable events.
Additionally, these liabilities can include back taxes (in other words, taxes from the previous year) or write-offs that reduce taxable income. One example of this is a loss carryforward, in which you could use current realized losses against future capital gains taxes.
Understanding The 1031 Exchange
We have provided in-depth discussions about the 1031 exchange in previous blogs. Here is a refresher:
- The 1031 exchange, also known as the like-kind exchange, helps defer capital gains taxes on the sale of real estate held for investment purposes.
- The process operates by permitting you to exchange proceeds from the sale of a relinquished asset into the purchase of a replacement asset of equal or greater value.
- To ensure the success of this exchange, you must collaborate with a qualified intermediary and must adhere to the in-stone deadlines set out by the IRS.
The operative word when it comes to the 1031 exchange is that it is a tax deferral tool. The process does not eliminate or reduce taxes, it simply means you don’t have to pay them immediately.
You'll Still Owe, Unless...
You can continue to use the like-kind exchange ad infinitum. There is no limit to the number of times you can swap properties. But, once you stop, you owe taxes on the capital gains from that original relinquished property exchange. The tax liability does not decrease over time. In fact, it can increase, depending on the amount of your capital gains.
The one exception to that tax increase is the use of like-kind exchange in estate planning. If you die after completing a 1031 exchange, your heirs receive the replacement property on a step-up in basis. The property’s value is pegged to the current market value, rather than what you originally paid for it. This can eliminate capital gains entirely for your heirs, potentially eliminating any pre-existing tax liability.
Otherwise, at the risk of sounding repetitive, the goal of the 1031 exchange is to help defer capital gains taxes, not to eliminate or reduce them. As such, before embarking on, or continuing, an exchange strategy, it’s a good idea to talk with your tax advisor or financial planner to ensure these activities meet with your investment goals.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor. There is no guarantee that the investment objectives of any particular program will be achieved. The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that they will be able to pay or maintain distributions, or that distributions will increase over time. Programs that depend on tenants for their revenue may suffer adverse consequences as a result of any financial difficulties, bankruptcy or insolvency of their tenants. All real estate investments have the potential to lose value during the life of the investment. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor returns, and may outweigh tax benefits. Because they are private placements, TICs are illiquid securities. There is no secondary market for TIC investments. Moreover, the form of ownership may require unanimous consent to sell a TIC interest.