Swap Tactic Lets You Defer Capital Gains Tax
When you sell an appreciated asset, you generally owe tax on the gain right away. Certain exchanges, known as swaps, let you postpone that tax by trading one asset for another rather than selling for cash. The most widely used version applies to real estate, and it comes with strict rules.
The like-kind exchange
Under Section 1031 of the Internal Revenue Code, you can defer gain when you exchange real property held for business or investment for other real property of a like kind. In current law, this treatment applies to real property only. It does not apply to stocks, bonds, personal property such as equipment or vehicles, or to your personal residence.
Like-kind is interpreted broadly for real estate. For example, rental houses, land, and commercial buildings can generally be exchanged for one another, but the property must be held for investment or used in a trade or business on both ends.
How it works in practice
Most exchanges are delayed. You sell the old property, and later acquire the replacement. To keep the sale from being treated as a taxable one, you must use a qualified intermediary to hold the proceeds. If the money touches your hands, the deferral can be lost.
- You must identify replacement property in writing within 45 days of closing on the sale.
- You must close on the replacement within 180 days of the sale, or by your tax return due date for the year, if earlier.
- The exchange is reported on Form 8824 with your tax return.
It defers, it does not erase
Your tax basis in the old property carries over to the new one, so the deferred gain is still there. If you eventually sell for cash, the gain is generally taxed then. Some investors keep exchanging for years. Heirs may receive a stepped-up basis, which can eliminate deferred gain, under the rules that apply to inherited property.
Watch for boot
If you receive cash or other property that is not like-kind, or if your debt on the new property is lower than it was on the old, that amount, called boot, is taxable up to your gain.
Other swap ideas
In a taxable investment account, swapping one security for a similar but not identical one can allow you to realize a loss while keeping your market exposure. Wash sale rules disallow the loss if you buy a substantially identical security shortly before or after the sale. Such swaps recognize gains or losses; they do not defer gains.
Questions to ask before you swap
- Is the property held for investment or business?
- Can you identify and close on a suitable replacement in time?
- Is the deferral worth the costs of the intermediary and the exchange?
- Does the new property fit your financial goals?
Details are on irs.gov. Because mistakes are expensive, talk with us before you sign a sale contract.
This article is general information, not tax, legal or investment advice for your specific situation.