Investments in rental real estate provide a unique opportunity to defer capital gains taxes under the like-kind exchange rules of Internal Revenue Code Section 1031. Unlike Individual Retirement Accounts (IRAs), the tax deferrals in a Section 1031 exchange are not subject to required minimum distributions, meaning that taxes can be deferred over an investor's entire lifetime.
The scope of Section 1031 has narrowed in recent years. Starting with the Tax Cuts and Jobs Act in 2018, Section 1031 applies only to exchanges of real property and not to exchanges of personal property or intangible property.
A like-kind exchange allows you to defer capital gains taxes when you sell real property used in business and reinvest the proceeds into a similar property. Most real estate will be like-kind when exchanged for any other real estate. For example, a residential rental home is like-kind when exchanged for an industrial building.
Here are the key steps to complete a like-kind exchange:
Identify the Property to Sell: The property you want to sell must generate business income, e.g., rental income. The property should not be held for personal use.
Find a Qualified Intermediary: You need a qualified intermediary (QI) to facilitate the exchange. The QI holds the proceeds from the sale and uses them to purchase the new property.
Sell the Original Property: Once you sell your property, the proceeds go to the QI, not directly to you.
Identify Replacement Property: Within 45 days of the sale, you must identify potential replacement properties. You can identify up to three properties regardless of their value, or more if they meet certain valuation criteria.
Purchase the Replacement Property: You must complete the purchase of the new property within 180 days of the sale of the original property.
Report the Exchange: Use IRS Form 8824 to report the like-kind exchange on your tax return.
Investors may seek Section 1031 capital gains deferrals through alternative entities such as partnerships, LLCs, and Delaware Statutory Trusts, but investing through these entities has advantages and disadvantages. These deferrals are tools for making tax-efficient real estate investments.
For additional information, see: