1031 Exchanges: Never pay capital-gains tax again—maybe

Paying taxes is not fun. For many people, it’s their biggest expense year in and year out. But maybe it doesn’t have to be. How so?

By taking advantage of Section 1031 of the Internal Revenue Tax Code. This section allows you to exchange one investment property for another without paying capital gains from selling the original investment property. The trick is that you must invest your capital gains into the next property.

Let’s look at an example. Assume that you bought a property for $150,000 10 years ago. And now you sell it for $200,000. Congratulations. You earned a tidy profit of $50,000 minus the government’s cut, which is better known as capital-gains tax.

Now let’s play out the same scenario using a 1031 exchange. Again, you bought the property for $150,000 and sold it for $200,000. But rather than cashing out, you buy a new property for $205,000. You still earned a tidy profit but now you didn’t pay any capital-gains tax. Instead, you invested your profits plus what you would have paid in capital-gains tax for a new, more valuable property.

At this point, careful readers are probably wondering: Does the capital gain disappear when you buy a new property? No. It sticks around but is deferred until you cash out in the future.

The power of this strategy is that you can use money you would have paid to the government to buy a bigger, better property. Over time, this advantage can really add up.

So far, so good. Now for some of the fine print.

First, Section 1031 only applies to properties owned as an investment or for use in your trade and business. Easy enough. Basically, any property held as an investment or to generate income qualifies, including raw land, residential property, commercial property, and more.

Second, the property you buy (known as the “replacement land”) must be of “like kind” with the property that you sold. This requirement sounds tighter than it is. In reality, it’s not saying that if you sell raw land, you must buy more raw land. You don’t. What it’s actually saying is that you need to have the same intent for the replacement property as you had for the original property.

Put differently: What matters is your intent, not the physical similarity of the original property and the replacement property. So, you can sell raw land and buy an apartment building. Or you can exchange an apartment building for several houses. And so on—as long as you have the same purpose for both the original property and the replacement one.

But be careful, there are a few exceptions. Section 1031 does not apply to properties that you fix and flip or land held for subdivision and sale. It also does not apply to primary or secondary residences (though there is a straightforward way to circumvent the restriction on primary/secondary residences).

Third, the old property and the replacement property must be in the same name. In other words, if you owned the old property in your name, then you must own the replacement property in your name. If, by contrast, you owned the old property through an LLC or a land trust, then your LLC or land trust must own the replacement property.

Not to worry though: Later if you want to shift the property title from, say, yourself to a land trust or LLC, you can. How long should you wait? The common wisdom is to wait one year before transferring ownership from yourself to your land trust or LLC.

This titling issue also causes headaches the other way around. Some real-estate investors own property in a land trust or LLC. If they want to sell that property and then use the sales proceeds plus a bank loan to acquire a bigger property, trouble can crop up.

The issue is that the bank will normally want the replacement property in your personal name (because if you default, it’s easier to collect from you than your trust or LLC). So, if the original property is titled under your trust (or LLC), but the bank wants the replacement property to be titled under your name, the 1031 exchange will violate requirement 3, and therefore fail.

Fortunately, there’s an escape clause for this situation: Transfer the original property to yourself before putting the property up for sale. Then the original property will be in your name as will the replacement property, thus making both the bank and Section 1031 happy.

Now let’s turn to another common scenario: What happens if three people own a company that owns property? What if one person wants to cash out while the other two want to reinvest in a bigger, better property? All parties can get what they want—provided that they prepare properly.

What will they need to do? Simple. The company should transfer the property to each partner as “tenants in common.” From there, the partner who wants to cash out can sell their share of the property. Meanwhile the other two owners will exchange their piece of the property for a replacement property. This process is known as a “drop and swap.”

If a 1031 exchange sounds interesting, it is. But do your homework. The process is littered with procedural traps and tricks that can wound and maim the uninitiated. The safest way to avoid these injuries is to work with an accountant and lawyer with experience doing 1031 exchanges.

This column is not intended to be taken as legal advice and is for informational purposes only. For specific cases, consult a lawyer.

Jordan Sundell (Special to the Saipan Tribune)
Jordan Sundell is a lawyer primarily practicing business and real-estate law. He formerly worked for the CNMI Supreme Court and Bridge Capital and is now general counsel for several real-estate companies, including JZ Group. His columns—focused mainly on real estate and small business—are published every other Tuesday. Contact Sundell at jsundell@jzgroupinc.com.