Q.  I want to sell some rental property that has really gone up in value and understand I can avoid capital-gains taxes with a 1031 Exchange.  How does that work?

A.  The real-estate market in the last few years has risen to the point that the valuation has become “irrationally exuberant.”

What’s the problem?  Probably due to the real-estate investing frenzy, many self-proclaimed experts are telling sellers with potentially huge capital gains on their real-estate holdings not to worry about paying capital-gains taxes.  They are advising them instead to sell their current holdings and buy other real estate via an IRS 1031 Exchange.

Many 1031 Exchanges are done with little understanding.  Some property owners think, “If I sell my rentals for X dollars, then I only need to buy other ones for an equal or higher price.”  Unfortunately, a 1031 Exchange is that there is no tax gain or loss if an investment property is exchanged for a similar or “like-kind” investment property.  You cannot exchange your personal residence for a rental property or exchange rental property for a residence you occupy.

Here are four of the requirements that people often fail to meet:

1. Deadline for identifying the new property.  You must identify the property you want to exchange into on or before the 45 day after you relinquish the previous property.

2. Timing of receipt of the replacement property.  You must close escrow at whichever time is earliest – within 180 days of the day you relinquished the previous property or the due date (including any extensions) of the income tax return for the taxable year in which the relinquished property was transferred.

3. Value of the new mortgage.  The mortgage or combined mortgages on the replacement property must be equal to or higher than the mortgage or combined mortgages on the relinquished property.  If it’s less, the difference is called “mortgage relief” or “mortgage boot,” and you have to pay tax on that.  It is a common problem with 1031 Exchanges nowadays.

4. A qualified intermediary is needed.  The seller cannot receive any money in hand in order for the 1031 Exchange to work.  A seller needs to use an accommodator or intermediary to hold all funds and use them for the replacement property purchase.

The intricacies of exchanges are best handled by a team that includes an accommodator, a real estate broker, and attorney or CPA. Assemble that team before the you put the property on the market. Otherwise, you run the risk of an error that could invalidate an exchange.

The information provided is not intended as legal or tax advice and may not be relied on for purposes of avoiding federal tax penalties.  All individuals, including those involved in a real estate transaction, are advised to meet with their tax and legal professionals.

Charlie Dunn, CRS
Prudential California Realty
11306 183rd Street, Cerritos, CA 90703
Direct Line: 562-430-4007
Make Yours a "DunnDeal" 

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