How to use like-kind exchanges to eliminate taxes on real estate gains

Most real estate investors have heard about the mythical like-kind exchange. This tax strategy is where you buy a new investment property to replace the old one, and you don’t have to pay tax on the sale of your old property.

What most investors don’t know is that there is a way to use like-kind exchanges to avoid tax on your real estate portfolio completely and still have the use of the cash and appreciation of your investment.

A like-kind exchange is also called a 1031 exchange after the Internal Revenue Code section that allows for the tax-deferred treatment of the exchange.

Originally, it was thought that you would have to find someone who wanted your property and do a direct exchange with them of your property for their property, but that’s no longer the case. Now, you can sell your property on the open market and then buy any property you want. Of course, there are a few rules you must follow. Here they are:

Equal or up

You must purchase a property that is the same cost or more than the sales price of the property you sell. This rule means that if you sell a property for $500,000, the property (or properties) you replace it with must cost at least $500,000.

Timing

You have to identify your new properties within 45 days of when you sell your old property. Then, you have to close on the purchase of the new property within 180 days of the day you closed on the old property. This rule is not 180 business days! It’s 180 calendar days.

Custodian of the cash

You cannot touch the cash in the exchange. You must hire a company to hold the cash from your sale and handle the purchase of the new property.

Any cash that comes to you is taxable, even if you only have access to it for one day or one hour. The company that holds the cash and does the paperwork for the transaction is called the “qualified intermediary.”

Before you go into your exchange, sit down with your tax adviser and review your situation. Here are a couple of ideas you might want to consider.

1. Is a 1031 exchange the best option?

Would you be better off recognizing the gain and not doing a 1031 exchange? Most people automatically think that not recognizing a gain is better than recognizing the gain, regardless of their personal situation — but that’s not always the case.

Suppose you have big losses from the stock market that you haven’t used. You can use those stock losses against the gain on your real estate. When you do this, you get to start over on your depreciation deduction with the new real estate.

You have effectively used an asset that was stuck (your capital losses from your stock) and converted it into useable assets (ordinary deductions from the depreciation on your new property).

2. Should I purchase the new property first?

So many times people buy the wrong property because they are pressured into replacing their old property within the 45-180 rules mentioned above.

Instead, consider doing a reverse exchange. In a reverse exchange, you purchase the new property before you sell your old property. This approach gives you extra time to find the property you really want.

You still have to use a qualified intermediary for the entire transaction. So contact the intermediary before you purchase the new property. A good qualified intermediary, in conjunction with your tax adviser, can make sure your transaction qualifies for tax-deferred treatment.

3. How can you get your money out of your property without paying taxes?

Eventually, you will want to use the money from the appreciation of your properties for something other than buying real estate. How?

Simply borrow the money. Rather than pay tax on a sale, just go to the bank for a line of credit or refinanced loan. Loans are not taxable. As long as you don’t do this near the time you do the 1031 exchange, the IRS won’t mind at all.

4. How can you turn your tax deferral into permanent tax savings?

We call this strategy “exchange until you die.” Keep doing like-kind exchanges whenever you sell a property. Eventually, you will die holding several real estate investments.

When you do, the deferred gain disappears. The tax liability on all of the depreciation that you have taken and on all of the appreciation on the property goes away when you die. After you die, your kids can sell the property and pay no tax at all.

Always plan real estate transactions with proper tax advice from a CPA who specializes in this area. Don’t ever try to do this type of planning on your own.

You can also review these Like-Kind Exchange rules in more detail in my book, “Tax-Free Wealth.” With the right counsel and advisers on your side, you never have to pay tax on your real estate gains.

Tom Wheelwright is the author of “Tax-Free Wealth,” CPA and CEO of ProVision Wealth. You can follow him on Facebook or Twitter.

Email Tom Wheelwright.