Depending on your circumstances, selling an asset, like a commercial property or business interest, can carry significant tax liabilities in the form of capital gains taxes. And investors can be blindsided by a huge tax bill when selling off an asset holding.

Fortunately, there’s a workaround that mitigates capital gains taxes! Enter the Like-Kind Exchange, also known as a 1031. In short, a like-kind exchange allows you to sell a business or real estate investment property and then purchase another similar asset without triggering capital gains taxes on the initial asset sale.

This tax deferral option could be a huge financial benefit if you’re contemplating such a transaction.

How Does a Like-Kind Exchange Work?

When you realize a gain on the sale of commercial or residential investment property, you’re obligated to pay capital gains taxes on your resulting profit. Depending on your income tax bracket, short-term capital gains (assets held for less than a year) are taxed between 10% and 37%, while longer-term capital gains (assets held for longer than a year) are taxed between 10% and 20%.

But under Section 1031 of the IRS tax code (from which the “1031 Exchange” takes its name), capital gains taxes can be deferred if you use the proceeds from your initial investment sale to purchase a property of equal or greater value.

What Assets Qualify For a Like Kind (1031) Exchange?

For the most part, any real estate property held for investment purposes is eligible for a like-kind exchange.

This includes income-producing single-family homes, vacation rental houses, and multi-family properties ranging from duplexes to apartment buildings. Commercial properties, including retail, office, industrial, and warehouse sites, also qualify. The only exception is your personal residence, which cannot be traded in a like-kind exchange.

You can also sell a business or your interest in a business and use the proceeds from the sale to purchase a property of equal or greater value in a like-kind exchange.

General Guidelines for Executing a 1031 Exchange

When processing a 1031 exchange, you’re required to file several tax forms with the IRS (and some state tax boards) and adhere to a mandatory timeline for identifying your exchange property and closing the exchange sale. Additionally, there is a specific protocol for handling exchange funds.

Due to these legal obligations, the IRS dictates that you must use a Qualified Intermediary (QI), also known as an Accommodator. A QI receives and holds exchange funds, advises you on compliance rules, and prepares all agreements and necessary exchange documentation to ensure your transaction is executed under the Internal Revenue Code and Treasury regulations.

Regarding deadlines, you must identify an exchange property within 45 days of the initial closing, and the subsequent purchase must close within 180 days of the prior sale’s closing.

What Are The Advantages of a Like-Kind Exchange?

The most obvious benefit is the tax deferral. Investors are often daunted by the potentially enormous tax bill associated with business equity and investment property sales. For example, if you purchased a property 20 years ago for $600,000 that’s now worth $4,000,000, your capital gains taxes would be over $1,000,000.

Also, there’s no limit on how many exchanges you can execute or how often. You could potentially trade every investment property you own in a 1031 exchange. And you can continue to trade up, using the proceeds from successive sales to purchase increasingly more valuable properties. An approach that puts your money to work instead of losing it to tax liabilities.

What Are The Disadvantages of a Like-Kind Exchange?

The major drawback of a 1031 exchange is that it’s a tax deferral, not a tax exemption. Meaning the tax liabilities do not disappear. You will eventually have to pay the capital gains taxes if you sell the property to cash out your investment.

The only avoidance is if you die and your heirs sell the property under the stepped-up basis rule. This tax exemption allows your heirs to sell an inherited property at its current value, eliminating the gains accrued over the time you held the property.

Considering a Like-Kind (1031) Exchange?

Capital gains taxes are the bane of most investors, particularly those in the real estate realm. But if you’re interested in or planning to sell an investment property and don’t necessarily need to pull cash out, a 1031 exchange is an excellent means to avoid capital gains taxes.

If you have questions about the tax liabilities of a potential real estate investment sale, get in touch for your FREE Consultation!