One of the benefits of holding real estate for investment is the ability to defer taxes on capital gains through what is known as a 1031 exchange. Section 1031 of the Internal Revenue Code provides for investors to delay capital gains on the sale of property as long as they invest the proceeds in a “like-kind” (same type) investment within 180 days.
Real estate investors have been using 1031 exchanges for decades to defer gains in properties and use the proceeds to invest in larger properties. With the recent decline in real estate values and the loss of some properties through foreclosure, 1031 exchanges may actually trigger capital gains tax for real estate investors.
For the thousands of people who have invested in 1031 tax-deferred exchanges, the real estate downturn may be coming home to roost.
Section 1031 exchanges allow real estate investors to defer their capital gains taxes as long as they roll the gain from the sale of one property into the purchase of a like-kind replacement property. With today’s sharp decline in commercial real estate values, their current property likely is worth less than what they paid for it.
If they sell their property, even if they don’t make money on the sale, they are going to trigger the capital gains taxes that were due from their previous sales. Selling at a loss does not eliminate those deferred taxes, according to Daniel Oschin, managing director of BGK-Integrated Group and president of BGK-Integrated Investment Services.
“Your taxes are never wiped out,” Oschin said.
It’s a situation that is likely to hit home with people who have traded properties over three, four or even five different legs of a 1031 exchange, re-leveraging them over the years and rolling significant gains into the property they’re currently holding.
What appears to be a loss, may in fact trigger taxable income, because of a low tax basis. This unfortunate situation can leave a real estate investor caught trying to find cash to pay Uncle Sam. (Jeff Brown details how this catastrophe was avoided here.)
Competent tax professionals are necessary for every real estate investor. A CPA or tax attorney should be contacted when considering a real estate investment decision.