Table of Contents Page Home Page

Can I avoid capital gains taxes?

QUESTION:

I own a house in New Jersey that I rent out to tenants. I would like to sell it but my accountant tells me I will have to pay thousands of dollars for capital gains tax. He also told me that if I do a 1031 Exchange, I can avoid the tax altogether. How is this possible?

ANSWER:

An IRS Section 1031 Exchange, or a "nontaxable sale," is a method of selling real estate which allows an owner of investment property to trade that property for new investment property without having to pay capital gains taxes on the transaction.

These transactions are also called "tax-deferred exchanges" because the owner is able to sell real estate without an immediate tax liability. Instead the owner can use the tax savings to invest in real estate that has greater value than the one just sold. This tax deferral treatment is often used as a way to build one’s real estate wealth.

Exchanging properties also allows owners to move their equity from property that is not meeting their investment objectives to a more satisfactory investment property.

Real estate exchanges offer excellent tax advantages. However, if the transaction is not structured to meet the requirements of all the IRS regulations, then the tax benefit will be denied. Besides the IRS tax regulations, there are numerous opinions, Revenue Rulings, and court decisions that apply to real estate exchanges. These can be traps for the unwary or ill-advised property owner.

In recent years, the IRS has finalized the regulations to provide clear rules for typical exchange transactions. The IRS has defined "safe harbor" tests for structuring exchanges. These "safe harbors" define the edges of the envelope of safety. If a transaction falls outside the safe harbor’s edge, the owner will not automatically be denied the tax benefit. However, such transactions will be more closely scrutinized by the IRS. One pitfall to beware of is that even if the transaction is within the edges of the safe harbor tests, the exchange will not qualify for Section 1031 treatment if the IRS determines that the owner has actual or constructive receipt of the sale proceeds before the owner has received the replacement property.

This information is not intended as specific legal advice to anyone and is based upon facts that change from time to time. Individuals should seek legal counsel before acting upon any matter involving the law.

Back to the top of the page