Capital Gains, If you sell real estate or personal property for a profit, the IRS is likely to assess capital gains tax on that profit. However, if your purpose in selling your property is to buy other property of a generally similar nature, the IRS has provided a way for you to defer capital gains tax indefinitely. This article explains how Section 1031 of the Internal Revenue Code works, and how you can use it to your advantage.
The IRS will allow you to defer capital gains tax indefinitely if you exchange one property for another property of “like kind” (excluding intangible property such as stocks, intellectual property rights and financial instruments). The reasoning is that since no sale took place, no funds have been generated with which to pay the tax. The IRS definition of “sale” is flexible – you may sell your property and buy another property later in the tax year without incurring liability for capital gains tax, as long as certain conditions are met.
The first condition that must be met is that the two properties must be of “like kind” as the IRS defines that term. Almost any two pieces of real estate are considered “like kind”, even if they differ greatly in value. With personal property, the rules are more complex and are listed on the IRS website. The second condition is that the property must be used for business or investment purposes. If you wish to sell your personal residence, Section 1031 is inapplicable, but you won’t need it anyway. The sale of a personal residence is usually not subject to capital gains tax.
Section 1031 also contains rules on making deferred exchanges of property. If you sell your property, you will have 45 days in which to locate a seller of “like-kind” property of your interest in purchasing it. After that, you will have 180 days from the date that your property was sold (or the date the next tax year ends, whichever comes first) to purchase the new property. You don’t even need to purchase the property whose seller you notified – you are allowed to purchase a “substantially similar” property and still classify the entire transaction as an exchange rather than a sale.
Remember that Section 1031 does not relieve you of liability for capital gains tax – it only defers liability. When you sell your new property (unless you exchange it under Section 1031 again), you will still have to pay capital gains tax.