Have you ever called your mutual funds family and exchanged the share in your growth fund for shares in a value fund? If so, you know that you pay capital gains taxes. A swap like this actually requires selling those growth fund shares.
Or try bartering your professional service. Offer, say, your medical services for a friend’s legal services to avoid income tax. If you’re audited, the IRS will nail you for not reporting the equivalent of wage income.
But if real estate’s your game, then swapping is a way of life. One of the sweetest tax breaks ever devised is the section 1031 exchange, which allows you to swap investment property on a tax-deferred basis.
Although sometimes known as like-kind exchanges, these transactions don’t have to involve identical types of investment property.
You can swap an apartment building for a shopping center, or a piece of raw land for an office building. You can swap a second home that you rent out for a parking lot.
It’s a tremendous deal, you can't do that with stocks or bonds or personal property.
Originally, Section 1031 transactions were designed for people who wanted to exchange properties of equal value. Suppose you own land in Oregon and you trade it for a shopping center in Rhode Island. If the values are equal, nobody pays taxes even though both properties may have appreciated since they were originally purchased.
One variation involves properties of unequal value. Let’s say you have a small piece of property, and you want to trade up to a bigger one by exchanging it with another party. You can make the transaction without having to pay capital gains tax on the difference between the smaller property’s current market value and your lower original cost.
That’s good for you, but your partner doesn’t make out so well. Presumably, you have to pay cash or assume a mortgage on the bigger property to make up the difference in value. Known as "boot"in the tax trade, your partner must pay tax on that part transaction.
To avoid that, you could work through an intermediary, who is often known as an escrow agent. Instead of a two-way deal involving a one-for-one swap, your transaction becomes a three-way deal.
Your replacement property may come from a third party through the escrow agent. Juggling numerous properties in various combinations, the escrow agent may arrange evenly valued swaps.
Under the right circumstances, you don’t even need to do an equal exchange. You can sell a property at a profit, buy a more expensive one, and defer the tax indefinitely.
You sell a property and have the cash put into an escrow account. Then the escrow agent buys another property that you want. He or she gets the title to the deed and transfers the property to you.
But you need to move fast. You must identify your replacement property within 45 days of selling your estate. Then you must close on that within 180 days. There is no grace period.
If your closing gets delayed by a storm or by other unforeseen circumstances, and you cannot close in time, you’re back to a taxable sale.
Some accountants and lawyers specialize in Section 1031 exchanges to make sure that you qualify.
Because it’s such a significant tax benefit, there are all kinds of restrictions and pitfalls that you’ve got to be careful of. You’ve got to dot all of you i’s and cross all of your t’s.
A Section 1031 transaction takes advance planning. Find an escrow agent that specializes in the transaction. Contact your accountant to set up the IRS form ahead of time. Some people just sell their property, take cash and put it in their bank account. They figure that all they have to do is find a new property within 45 days and close within 180 days. But that’s not the case.
As soon as (sellers) have cash in their hands, or the paperwork isn’t done right, they’ve lost their opportunity to use this provision of the code.
Section 1031 doesn’t apply to personal residences. But the IRS lets you sell your principle residence tax-free as long as the gain is under $250,000 for individuals and under $500,000 if you’re married.