When is a 1031 exchange tax free?

Often I read articles that claim 1031 exchanges are tax free.  I look for the rebuttal that explains the tax is actually deferred, not eliminated. But there are two specific cases and possibly a third where the tax can be eliminated. 

The tax referred to is the federal and state (where applicable) capital gains and recaptured depreciation tax that are triggered when selling real and personal property held for investment or in a trade or business. See an earlier blog on the three easy steps to determine the tax.

The two scenarios where the tax is eliminated are:

• 1. When a beneficiary receives the property following the death of the Taxpayer. At the time of receipt the basis is stepped up to the current value based upon comparable real estate values. If the beneficiary elects to sell the property, there is no tax due. If held and later sold, then a capital gains tax is due on the difference in value at receipt and the current value.
• 2. If the property is converted into a primary home. First the property must be held for a minimum of two years as a rental, then converted to a primary residence and held through year five. The deferred gain from the first sale can be offset by the same value of the appreciation given the appreciation does not exceed $250,000 filing as an individual or $500,000 filing jointly.

There may be another way to effectively make the 1031 exchange tax free if the replacement property is donated to a charitable trust.  As is always the case, seek the counsel of your accountant for financial advice.  They know your specific situation and may suggest another alternative.  But at least you will have a head start.