In the world of real estate investing, business owners often face a significant capital gains tax expense. A property owner must pay this transaction tax after selling a capital property that appreciates in value. For sales of assets held for one year or less, the gains are considered as short-term and taxed at a taxpayer’s ordinary income tax rates, which range from 10% to 37%.
If the asset is held for more than a year, the profits from the sale are categorized as long-term capital gains and taxed at 0%, 15%, or 20%, depending on the taxpayer’s income. These long-term capital gains tax rates are structured to encourage extended investment. The long-term capital gain tax rates that real estate investors would have paid in 2024 (along with the inflation-adjusted income threshold amounts for 2025) are listed below:
Married Filing Jointly
- 0% for taxable income up to $94,050 (for 2025: up to $96,700)
- 15% for taxable income between $94,051 and $583,750 (for 2025: $96,701 to $600,050)
- 20% for taxable income above $583,750 (for 2025: over $600,50)
Single
- 0% for taxable income up to $47,025 (for 2025: up to $48,350)
- 15% for taxable income between $47,026 and $518,900 (for 2025: $48,351 to 533,400)
- 20% for taxable income above $518,900 (for 2025: over $533,400)
Like-kind Exchanges
A quick calculation shows appreciation of $100,000 on an investment property would result in a $15,000 or $20,000 capital gains tax for many investors. However, this tax liability can be delayed through a Section 1031 Like-Kind Exchange.
The basics of Section 1031 are quite simple, and there are two ways to complete such a transaction. The first, and easiest, option is to trade property-for-property from one investor to another. The second, more complicated and more common option, is to use a third party known as a qualified intermediary. To avoid capital gains tax through this route, the investor must sell the property, and let the proceeds go into the hands of the intermediary. Following the transaction, the investor must meet specific time requirements before reinvesting the proceeds into a like-kind property.
The 1031 exchange strategy is available for any type of business entity or taxpayer, as long as it meets the following requirements, which are explained in the following paragraphs.
- The properties exchanged must be real property.
- The property transferred and received must be held for productive use in the transferor’s trade or business or for investment purposes.
- The property transferred and received is of a like-kind.
- The transaction meets specific timing requirements.
First, the “real property” requirement means that the properties must be fixed to the ground, or in other words, buildings. Prior to January 1, 2018, personal property (cars, appliances, furniture) also qualified under Section 1031, but the Tax Cuts and Jobs Act (TCJA) allows only the exchange of real property.
Second, the taxpayer must have held the surrendered property for trade, business or investment use, and the taxpayer must intend to hold the replacement property for trade, business or investment use. These purposes are interchangeable; for instance, the surrendered property may be business property, and the replacement property may be investment.
Third, the IRS specifies that “like-kind” pertains to type and not quality of the property transferred. Therefore, an objectively less desirable property can be exchanged for a brand new, renovated property because they are of a similar investment property type. However, foreign real property is not seen as like-kind to United States real property.
Last, the exchange transaction must fall within two specified windows. An investor has 45 days from the sale of their property to decide what investment he/she would like to acquire next. Then, the investor must close on the property selected within 180 days. These windows start simultaneously on the day that the property owner sells the original property and the intermediary collects the proceeds. If either task is not completed within their respective windows, then the investor must pay capital gains on appreciation from the sale.
The following example provides detail of a 1031 exchange:
- Phoebe purchased an investment rental property in 2018 for $200,000
- She decides she wants to sell this investment property in 2025 for $250,000
- Phoebe expects her 2025 taxable income before the sale to total $100,000, which puts her in the 15% capital gains tax bracket
Using the information presented above, a sale of the property would require Phoebe to pay $7,500 in capital gain taxes on the $50,000 appreciation in her investment building. If she chooses, instead, to leverage the rules of a Section 1031 Exchange, she can defer the capital gains tax into the future.
Final Thoughts
A like-kind exchange provides a tax-saving alternative to selling property outright. The sale of property may create a tax liability on any gain realized on the sale. A like-kind exchange, on the other hand, allows an investor to avoid gain recognition through the exchange of qualifying like-kind properties. Under Section1031, the gain on the exchange of like-kind property is effectively deferred until the investor sells or otherwise disposes of the property receives in the exchange. Form 8824, Like-Kind Exchanges, is used to report the transaction.
Additional tax implications may result from sales or exchanges of real property. Investors should consult with a professional to insure that all relevant provisions are considered in order to minimize tax liability. Contact a GYF Tax Professional at 412-338-9300 for assistance.
