How to Defer Capital Gains Tax & Grow Your Portfolio

You can defer capital gains tax on the sale of a commercial property. In fact, thousands of people do this every year. A 1031 exchange involves selling assets and rolling the potential capital gains tax into the basis of assets you buy. 

We’ll explain what 1031 exchanges are, how they work, and why you might consider one to defer capital gains tax. 

What Are Capital Gains & How Are They Calculated?

Capital gains are taxes assessed when an investor sells an asset and makes a profit. The Internal Revenue Service (IRS) asks taxpayers to identify their profit and then pay the taxes they owe within that tax year. 

The amount of capital gains tax varies by income. This table can help you understand the differences:

Income (Single)	Income (Married Filing Separately)	Income (Married Filing Jointly)	Tax Rate
Less than $44,625	Less than $44,625	Less than $89,250	0%
$44,625 to $492,300	$44,625 to $276,900	$89,250 to $553,850	15%
More than $492,300	More than $276,900	More than $553,850	20%

Source

Obviously, paying these taxes can be a burden. In extreme cases, the fees could wipe out the potential profits from your sale. To ensure that they don’t lose too much, smart investors investigate their options and look for ways to save the money they’ve earned. 

How to Defer Capital Gains Tax

The easiest and most effective way to preserve your profits is to defer your capital gains tax via a 1031 exchange. With this method, you sell an underperforming property, purchase a new one, and roll your taxes into the new asset. 

The IRS has very strict rules regarding 1031 exchanges. Most importantly, investors are told they can only sell or buy properties that are held for use as an investment. That means you can’t use these transactions to sell your primary home or buy a new one. Instead, you must deal with properties you’re planning to rent or otherwise make money from. 

You also can’t touch the proceeds of the sale in any way, or the entire transaction becomes taxable. Instead, you must hire an outsider (a qualified intermediary or QI) to hold the funds for you and release them for the purchase. This safe harbor ensures that you don’t take possession of the funds and pay a tax bill you’re hoping to avoid. 

Unlike traditional real estate transactions, 1031 exchanges have tight time frames. From the moment you sell your property, you have 45 days to identify replacement properties. You must complete the transaction within 120 days of the sale. 

Deferral vs. Forgiveness

Choose a 1031 exchange, and you won’t have to pay a capital gains tax immediately. However, that bill doesn’t disappear. Your taxes are deferred. They’re not forgiven. 

The IRS says many investors are confused about this key point. As a result, they don’t track their taxes properly. Unfortunately, this can lead to nasty surprises down the road. 

When you sell a replacement property purchased in a 1031 exchange, the taxes you’ve deferred are due. You must also pay taxes on any profits you’ve generated since you bought the property and when you sold it. 

To meet your tax obligations, you need detailed paperwork about how much is deferred and how much is new. If you haven’t tracked your property carefully, it’s hard to provide accurate figures. 

In general, it’s nearly impossible to get a real estate tax bill forgiven. Beware of companies that claim they can eliminate all of your taxes when you’re selling an investment. 

Is Deferral Right for You? 

If you defer capital gains tax, you’re not required to pay your bill within the tax year that you sell a property. If you’re short on cash right now and feel comfortable with pushing out the deadline, this could be a smart strategy. 

If you purchase something you’ll hold onto indefinitely, your taxes may never come due. Similarly, if you sell your replacement property via another exchange in time, you won’t pay those taxes at the time of that sale. 

However, you must always remember that deferred taxes could come due at some point. If you’d rather simply sell the property and pay the taxes now, this is a simpler approach that might make accounting easier.

Defer Capital Gains in 7 Steps 

You’ve decided that pushing your tax obligations out is a smart strategy for your investment portfolio. How can you get started? A 1031 exchange is a complicated process, but by following steps in sequence, you can get it done properly.

These steps are involved in a 1031 exchange:

1. Hire a qualified intermediary. Remember that you can’t touch the proceeds of your asset sale. You’ll need a QI to hold your money for you and release it for the purchase of the new property. 

2. Identify your property. You must pick an item from your portfolio and place it for sale. Ensure that your realtor knows it will be part of a 1031 exchange. 

3. Sell that property. Work with your realtor to find a buyer for your property.

4. Ensure the QI holds your profits. When the property sells, the QI must accept the profits and hold them in an account for you. 

5. Identify a property to purchase. Within 45 days of the sale, you must identify a replacement property legally. That means writing down the details, signing the document, and giving it to your QI.

6. Buy that property. Close on the deal of the item you’ve legally identified. Your QI must release the funds for you. The whole transaction must be completed within 120 days of the sale of the property.

7. Keep track. Remember that your taxes are deferred and not forgiven. Work with your accounting team to ensure you’re ready for the bill when it comes. 
   

Get Help With Your 1031 Exchange 

A 1031 exchange is a great method you can use to expand your portfolio. You can eliminate a non-performing property from your asset list and exchange it for something with a better option. And you won’t have to worry about paying capital gains tax immediately. 

At 1031 Pros, we can work as your qualified intermediary and ensure your transaction runs smoothly. We specialize in these types of real estate deals. In fact, it’s all we do. Contact us to find out more and get started on your transaction today. 

Frequently Asked Questions 

What types of property can I include in a 1031 exchange?

A 1031 exchange is designed for investment properties. That means you can’t use this process to buy something like a property you want to use as your primary home. You also can’t use it to sell the home you’ve been living in with your family. 

Can I buy a property first?

Yes, you can. A reverse 1031 exchange involves buying a property and parking it with a QI. Then, you identify a property you want to sell (within 45 days) and sell it (within 120 days). These transactions are complex, but they’re far from impossible. An expert’s guidance can make the process smooth and easy.

Can you sell a vacation home with this method? 

It depends. If you’ve used the property as a vacation rental and have rented it for about 90% of the time, you can sell it via a 1031 exchange. However, if you’ve never rented the property, it’s not considered an investment and can’t be sold this way. 

Can you buy a vacation home with this method?

It depends. You must rent out the property the majority of the time at fair market value. If you can’t bear to rent out the property, you can’t use this method to purchase it. 

Can you be your own qualified intermediary?

No. The IRS explains that you can’t work as your own qualified intermediary. You must hire someone to take on the work for you. Skipping this step could nullify your transaction, resulting in a tax payment.

What happens if you never sell the property?

If you defer capital gains tax with a 1031 exchange, the bill comes due when you sell the replacement property. If you never sell the property, the taxes are never due. That means you can pass the property to your heirs without the expectation of a tax. 

Can you use another exchange to sell the property?

Yes. Assets you purchase via a 1031 exchange can be sold in a different 1031 exchange. You’re not required to hold the property forever or sell it and pay the taxes at some point. If you use another exchange, the original taxes are deferred yet again. 

Can I take cash out and still defer taxes?

No. If you accept money from the transaction, it’s considered a boot. You’ll be assessed taxes on that boot. The taxes you’ll owe on the remainder of the transaction are deferred. 

References

Topic No. 409, Capital Gains and Losses. (January 2024). Internal Revenue Service. 

Section 1.1031(k)-1. Internal Revenue Service. 

Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service. 

Capital-Gains Tax Hits More Home Sellers. (May 2024). The Wall Street Journal.