A 1031 exchange is an investment property  exchange process that can assist in deferring taxes. We answer a question here.

Q: I currently own two rental properties. The first house is paid off. The second property still has 14 years on the mortgage.

I am considering selling the first house because it’s not earning all that much in the way of income after annual property taxes and other expenses. My thinking is that I would like to use 100 percent of the proceeds to pay down the mortgage on the second rental property.

I understand that the capital gains tax can be deferred if the proceeds are used in a like-kind exchange, but all of the examples and explanations I can find are for properties procured after the sale of the first property.

Would I still qualify for that deferment if I already own the house into which the proceeds are rolled?

Thank you!

A: The short answer is, unfortunately, no. But let’s back up so we can walk you through one of the great tax breaks still available that allows investors to defer paying tax on profit as it relates to real estate.

A 1031 exchange, also known as a Starker Trust, allows an investor to sell a piece of real estate, and defer any capital gains taxes and depreciation recapture taxes owed by selling the first property and identifying a replacement property within 45 days, then closing on that new property within 180 days. There is also a reverse exchange, which allows an investor to identify the replacement property and purchase it first, as long as the original investment property is sold within a certain period of time.

With a regular 1031 exchange, the funds must be held by a third-party agent at the time of the sale, and you may not use those funds except to buy a new like-kind property. Furthermore, the real estate investment property can’t be for personal use.

To qualify for a 1031 exchange, the real estate you are selling and buying must be a “like-kind,” meaning a commercial, industrial or investment piece of real estate for another piece of real estate. You can sell an apartment building and use a 1031 exchange to buy a shopping center. But you can’t sell real estate to buy non-real estate. (You can use 1031 exchanges for other types of investments, such as airplanes and stamp collections. But since this column is about real estate, I’ll simply refer to real property.)

The problem you have is that you already own the replacement property and don’t qualify for the deferment of taxes under IRS rules. You cannot sell off your first piece of real estate and use money from that sale on your other property to pay down the mortgage . You’d have to buy another property, one that costs at least as much as what you’re selling the original property for, and then you’d have to meet specific deadlines.

The bigger problem with your plan is if you don’t buy a replacement property and qualify for a 1031 exchange, you will not only owe taxes on any profit but you will have to pay back any depreciation you took over the years at 25 percent. That can be a hefty chunk of your cash.

The rules for 1031 exchanges can be complicated, but you should talk to a 1031 exchange expert to walk you through your options. You might find another situation that might fit your situation. Some limited situations might allow you to sell your current building and use that sale to add on to your current building. You wouldn’t pay down the mortgage, but if you were looking to construct a new building on land that is part of the property you want to keep, you might be able to do that. Again, talk to a professional before you buy, sell or refinance either property.

Please consult with your tax preparer or real estate attorney so that you fully understand the impact before you make this move. Before you make the appointment, you might want to download IRS Publication 544, Sales and Other Dispossession of Assets and Form 8824, Like Kind Exchanges.

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