How to Avoid Real Estate Capital Gains Taxes

Aerial view of the farm

Aerial view of the farm

Investing in real estate can help you diversify your investment portfolio by adding physical assets and providing you with inflation protection. If you are or aspire to be a real estate investor, you will be interested in these exchanges because they give you the opportunity to transfer your real estate investments tax-deferred. These exchanges give you the opportunity to have a dynamic real estate portfolio that you can adjust to market and economic conditions without incurring large tax liabilities. Here’s how they work.

If you need advice on diversifying your portfolio or adding physical assets to your holdings, consider working with a financial advisor.

Similar exchange, definition

A similar exchange occurs when an investor wants to sell a property and avoid the capital gains tax that is usually levied. An investor can use a similar exchange to sell a piece of real estate and buy another piece if the piece he is buying is similar to the piece he is selling. A similar exchange is permitted under Section 1031 of the Internal Revenue Code (IRC). Both equal exchange and homogeneous property are defined in section 1031.

Homogeneous property consists of real estate assets that are so similar in nature that they are suitable for an equal exchange. The Internal Revenue Code defines like property as any property held for investment, trade, or business purposes under section 1031. Asset class or asset quality is not used to define like property. Personal property cannot be used in an equivalent exchange. Profit from the transaction is not exempt from taxation. They are tax deferred.

Section 1031 of the IRS Code exempts the seller of real estate from paying capital gains if the property is held for business and investment purposes. The seller must acquire a homogeneous property each time he sells the property in order to defer taxes for as long as possible.

Similar exchange, types

There are four types of such exchanges:

  • Simultaneous – Simultaneous exchange is quite simple. This is a simultaneous exchange of one qualifying property for another with the closing of the transaction on the same day.

  • Postponed – Delayed exchange may be the most common. The seller is selling the property and has 45 days to determine the property to be exchanged for it. The seller then has 180 days to complete the sale. The exchange mechanism is often used to facilitate a pending exchange to ensure that it does not become a taxable event.

  • Provide recourse – A reverse exchange occurs when a property is purchased that will be replaced and the seller has 180 days to sell the original property.

  • Improvement – Upgrade Exchange requires purchased property to be placed with an intermediary for 180 days while construction or upgrade is in progress.

Exchange of similar goods, terms and conditions

Real estate concept graphics

Real estate concept graphics

In order for a property to qualify for an exchange, several conditions must be met. The property must be used in trade, business or investment. Personal property is not eligible. The property must be the same as the property it replaces. Usually real estate is no different from other real estate, if none of the plots is for personal use. Using a medium of exchange for a transaction helps ensure that no mistake is made in the matter of personal property.

There are also a number of rules that must be observed when exchanging such goods.

  • When the new property is finally sold, that is when capital gains tax is paid.

  • Since the entry into force of the Tax and Employment Act of 2017, only commercial or investment property can be exchanged.

  • The exchange must be identical in nature.

  • The property to be replaced must be of the same or higher value.

  • The owner of the original and replaced property must be the same person.

  • The property must be purchased within 45 days and the transaction closed within 180 days.

bottom line

model house

model house

Real estate investors who frequently engage in real estate transactions should take advantage of such exchanges whenever possible. Since real estate usually looks like other real estate, the rules may not be as complicated as they seem. The most challenging issue may be the relatively short timeframes to complete the acquisition and close the deal.

Investment Tips

  • Investors considering a similar exchange should weigh the pros and cons carefully. This is where a financial advisor can be invaluable. Finding a qualified financial advisor is not difficult. The free SmartAsset tool matches you with up to three financial advisors who serve your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find a consultant to help you reach your financial goals, start now.

  • If you decide to build your investment portfolio on your own, make sure you are ready for it. SmartAsset offers you a range of different online investment resources to help you sort things out. Check out our free asset allocation calculator today.

Photo credit: ©iStock.com/Bim, ©iStock.com/anyaberkut, ©iStock.com/turk_stock_photographer

The post “An easy way to avoid capital gains tax when investing in real estate” first appeared on the SmartAsset blog.

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