Here’s How to Avoid Paying Capital Gains Tax When Selling an Investment Property

What is 1031 Exchange?

A 1031 exchange is a way for real estate investors to avoid paying taxes when selling an investment property by reinvesting the sale’s proceeds to buy a new property.
Here’s an example. Let’s say you bought an investment property for $250,000 and you sell it for $300,000. Instead of cashing out on that $50,000 and being taxed heavily on it, you can put that money toward purchasing another investment property to defer your tax liability.
There are many different ways to use 1031 exchange. You might use it to sell a smaller property and upgrade to a larger one. Or you might want to relocate and purchase in a new area. You can continue to defer the taxes as many times that you want as long as you don’t actually receive any proceeds from any of the properties.

Available Properties to Do 1031 Exchange With:

The property you acquire in a 1031 exchange must be "the same nature or character" as the property you sell. “Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment,” according to the IRS.
That doesn’t mean it has to be the exact same type of property. A condo doesn’t need to be exchanged for another condo or a duplex doesn’t need to replace another duplex. You just have to purchase another property that you want to use as an investment.
Here’s an example: you cannot sell an investment property duplex and purchase a vacation home to be used for your personal family vacations. (We’ve outlined specific vacation home guidelines below). However, you can sell an investment townhome and purchase a commercial building as long as both of them are investment properties.

Available Multi-Family Properties To Do 1031 Exchange With:

The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary.
The second limit is that you have 180 days for the entire exchange process to be completed. That means you have 180 days from the sale of the original property to close on the replacement property.

If the following criteria is met, a vacation home or second home qualifies as a relinquished property:

The vacation home is owned by the taxpayer for at least 24 months immediately before the exchange
In each of the 12 month periods, the taxpayer rents the vacation home to another person at fair rental to another person for 14 days or more
The homeowner’s personal use of the vacation home does not exceed more than 14 days or 10 percent of the number of days during the 12 month period that the home is rented at fair rental value.

If the following criteria is met, a vacation home or second home qualifies as a replacement property:

The vacation home is owned by the taxpayer for at least 24 months immediately following the exchange
In each of the 12 month periods, the taxpayer rents the vacation home to another person at fair rental to another person for 14 days or more
The homeowner’s personal use of the vacation home does not exceed more than 14 days or 10 percent of the number of days during the 12 month period that the home is rented at fair rental value.