Tax-deferred exchanges can be better than property sales. When you sell investment property, you’ll owe tax not only on any appreciation but also on the amount you’ve depreciated. In some cases, all the sale proceeds will be taxed.
Suppose you own an apartment building you bought many years ago for $600,000. You have fully depreciated the property so your “basis” in the building is now zero. You no longer want to own the building and you have a buyer willing to pay $1 million.
Altogether, your federal tax bill on such a sale will be well over $200,000. After paying off your mortgage and covering all the other costs, you might wind up with little in your pocket.
Instead, consider a tax-deferred exchange, authorized under Section 1031 of the tax code. Such an exchange must involve investment properties (not personal residences) but the properties need not be perfect pairs. Your apartment building may be swapped for any type of investment property.
If certain conditions are met, no tax will be incurred on the transaction. Indeed, if you hold onto the replacement property (or another property acquired in a subsequent exchange) until your death, your heirs will inherit the property with a step-up in basis to current value. They can sell the property they inherit and owe no income tax on any prior appreciation. (The property will be included in your taxable estate, however.)
Most swaps today involve the services of an intermediary known as an “accommodator.” After you sell your original property, the proceeds go to the accommodator, who puts the money into an escrow account. (Your relatives and business associates can’t serve as an accommodator.)
After you transfer your property, you have 45 days to identify potential replacement properties, in writing, to the accommodator. Several properties may be identified, so you’re covered in case an intended acquisition falls through.
