How to avoid real estate capital gains taxes

Aerial view of a farm

Aerial view of a farm

Investing in real estate can help you diversify your investment portfolio by adding physical assets and providing a hedge against inflation. If you’re a real estate investor, or if you aspire to be one, you’ll want to learn about similar exchanges because they give you the ability to move your real estate investments on a tax-deferred basis. Similar trade-ins give you the opportunity to have a dynamic real estate portfolio that you can adjust according to market and economic conditions without incurring a high tax burden. Here’s how they work.

If you’re looking for advice on how to diversify your portfolio or add physical assets to your holdings, consider working with a financial advisor.

Kind exchange, definition

A similar exchange occurs when an investor wishes to sell a property and avoid capital gains tax that would normally be assessed. The investor can use the similar exchange to sell one lot of real estate and buy another lot as long as the lot he buys is similar to the lot he sells. Such an exchange is authorized as a Section 1031 exchange under the Internal Revenue Code (IRC). Both like-type exchange and like-type ownership are defined in Section 1031.

Similar ownership is composed of real estate that is so similar in nature that it qualifies for a similar exchange. The Internal Revenue Code defines like ownership as any property held for the purpose of investment, trade, or business under Section 1031. The grade of assets or quality of assets is not used to determine like ownership. Personal property cannot be used in such an exchange. The capital gains from the transaction are not tax exempt. I’m in a tax break.

Section 1031 of the IRS Code exempts the seller of the property from paying capital gains as long as the property is for trading and investment purposes. The seller must purchase similar properties each time he sells property in order to defer taxes for the longest period of time possible.

Kind exchange, Guys

There are four types of similar exchanges:

  • Simultaneous – Simultaneous trading is reasonably simple. It is the simultaneous exchange of one qualifying property for another with the closing of the transaction that day.

  • Deferred – Deferred exchange may be the most common. The seller sells the property and has 45 days to identify the property that will be exchanged. Then, the seller has 180 days to complete the sale. An exchange facility is often used to facilitate deferred exchange to ensure it does not become a chargeable event.

  • Inversion – A reverse exchange occurs when the property that will be the replacement property is purchased and the seller has 180 days to sell the original property.

  • Improvement – An improvement swap requires the purchased property to be placed with a broker for 180 days during construction or improvement.

Similar exchange, conditions and rules

Real estate concept graphic

Real estate concept graphic

For a property to be eligible for an exchange, several conditions must be met. The property is to be used in a commercial, business or investment purpose. Personal property does not qualify. The property must be similar to the property it is replacing. Usually, real estate is similar to other real estate as long as neither parcel is for personal use. Using an exchange service for the transaction helps ensure that no mistake is made regarding the matter of personal ownership.

There are also a number of rules that must be followed when making a similar trade.

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

  • As of the 2017 Tax and Jobs Act, only commercial or investment properties can be traded.

  • The exchange must be of an identical nature.

  • The replacement property must be of equal or greater value.

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

  • The property must be acquired in 45 days and the transaction closed in 180 days.

The bottom line

Model house

Model house

Real estate investors, who engage in frequent real estate transactions, should take advantage of such exchanges when they can. Since real estate is usually similar to other real estate, the rules may not be as difficult to follow as they seem. The more difficult issue may be the relatively short time frame to complete the acquisition and close the deal.

Tips for investing

  • Investors who are contemplating a similar swap should think carefully about the pros and cons. That’s where a financial advisor can be invaluable. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisors at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you reach your financial goals, get started now.

  • If you’ve decided to build your own investment portfolio, you should make sure you’re prepared. SmartAsset has you covered with a number of different online investing resources to help you figure things out. Check out our free asset allocation calculator today.

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The post A simple trick to avoid capital gains tax on real estate investments first appeared on the SmartAsset Blog.

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