Given a choice of paying income tax now or paying later, almost all of us would pay later. We can keep the dollars otherwise paid in tax and have them continue to earn an investment return for us.
The income tax code provides to sellers of real property the opportunity to make this choice. Unlike most other asset sales, with real property, the tax due on a sale may be deferred if the seller reinvests in other real property. This tax provision is commonly known as a “like-kind exchange” or “Section 1031 exchange.”
To qualify for the deferral does require careful planning and compliance with the tax code requirements. You must identity the replacement property within 45 days of the sale and you must close on the new property within 180 days of the sale. There is no forgiveness if the either the 45 or 180 day rule is not met.
Finding a suitable replacement property – you may identify up to three possible properties – will require more than the 45 days permitted. So you have to start the selection process well in advance of the closing date. Give yourself ample time to investigate possible new properties so you can find one or more suitable to your investment needs.
To completely defer the tax on the property sale, the value of the replacement property must be at least equal to the value of the property sold. You can acquire a more expensive property but if you trade down in value there will be some taxable income on the sale.
With careful planning you may construct a new building with the sale proceeds and in can even acquire the replacement property prior to the sale. Advice from an experienced tax professional is essential to be sure you meet all the requirements.
Fortunately, “like-kind’ has a very generous definition. Essentially any other real property will be eligible as a replacement property as long as it is either used in a trade or business or held for investment. A seller of land may acquire improved property and a seller of improved property may acquire land. The question does arise about reinvesting in a second home or resort property. For a second home to quality it must be a rental property and not a personal use property – use care to comply with these requirements.
The appeal of tax deferral is obvious, but do use caution. The new property can have different characteristics – less control, less liquidity, more risk. In some situations, just paying tax on the sale can be the right choice.
If a real property sale is ahead, explore the opportunities for deferral to see if it can work for you.
