1031 Exchange: Deferring Capital Gains Taxes on Investment Properties

1031 Exchange - Deferring Capital Gains Taxes on Real Estate

A 1031 exchange allows investors to defer paying capital gains taxes on the sale of investment properties, provided they reinvest the proceeds into another “like-kind” property. The term “like-kind” is expansive, covering various types of real estate, from residential rental properties to commercial buildings and vacant land.

The key requirement for a property to qualify for a 1031 exchange is that it must be held for productive use in a trade or business or for investment purposes. However, the IRS explicitly excludes property held for personal use from like-kind exchanges. Since primary residences are considered personal use properties, they do not qualify for the tax deferral benefits of a 1031 exchange.

For those selling a primary residence with substantial appreciation, capital gains taxes are a significant consideration. When a primary residence is sold, the homeowner will be subject to capital gains taxes on any profit realized from the sale. And in the case of a state like California, these capital gains are taxed at ordinary income tax rates and not preferential capital gains rates.

The IRS and most states do provide an exclusion from these taxes under certain conditions. For individuals, up to $250,000 in capital gains can be excluded, while married couples filing jointly can exclude up to $500,000, provided they meet ownership and usage criteria. This exclusion applies if the homeowner has owned the property for at least two of the last five years and used it as their primary residence.  However, for homes with substantial appreciation, the gains in excess of any exclusion will be taxed.

While a primary residence itself cannot be directly included in a 1031 exchange, there are strategies that can potentially allow homeowners to benefit from both the primary residence exclusion and the 1031 exchange deferral.

One approach involves converting a primary residence into an investment property by renting it out for at least two years before selling. By meeting the IRS’s requirement for holding the property for investment purposes, homeowners can then proceed with a 1031 exchange upon sale.

Another complex yet viable strategy involves properties with multiple units, such as duplexes. Homeowners can live in one unit and rent out the other(s) at fair market value. When selling such a property, the unit occupied as a primary residence may qualify for the capital gains exclusion, while the portion allocated to the rental unit(s) can potentially be eligible for a 1031 exchange.

With proper planning and qualifications, these approaches can be combined with gain exclusions when exchanging a property that was once a personal residence in a 1031 transaction.  However, navigating the intersection of 1031 exchanges, capital gains taxes, and primary residence exclusions requires careful planning and professional guidance. Tax laws can be intricate, and the consequences of missteps can be costly. Every fact pattern is unique, so consulting with a qualified tax advisor or real estate professional is highly recommended to ensure compliance with tax regulations and to maximize tax-saving opportunities.

Voss Real Estate Advisors

July 22, 2024

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