What is described is a little known law which permits the seller of commercial or rental real estate, or land to pay no Federal or state capital gains taxes on the sale. (Primary residences and vacation homes can also be made to qualify.) It doesn’t take a math wizard to figure out that on a sale of low (or no) basis property the tax and transaction costs (Federal, state, broker, legal) can exceed 30%.
Let’s use you as an example here. Pretend that you own real estate someplace in the U.S. that you have depreciated, etc., and for which you now have a cash buyer. Suppose further that you would like to acquire a new property someplace else with the money.
If you go through a regular closing, the capital gains taxes on the transaction become due immediately. These taxes are now virtually impossible to avoid because buyers are now required to give the IRS your name, Social Security number, the date of sale and the gross amount paid, all via the mechanism of a 1099 form. The Federal Government is alerted to look for the sale on your next tax return, and, of course, their information is shared with the states. Depending on the cost basis of the property you have just sold, you now have as little as two-thirds left available to reinvest, after taxes.
Furthermore, when you repurchase, the seller of the property you buy also has to pay capital gains taxes, and the IRS is alerted to look for him or her too via the 1099 which you are required to submit under that seller’s name. So in a normal sale and repurchase, the government gets tax revenue twice, once from you and once from the person you buy from.
However, pretend now that you structured your closing as a Section 1031 Exchange instead of a sale:
Does your buyer get what he or she wants, at Step 1? Yes.
Is a 1099 issued to you, evidencing the sale? Yes, but language is added to inform the IRS that a Section 1031 Like-Kind Exchange is taking place and to look elsewhere on your return for an accounting.
What happens to the money? It goes into a special escrow account at a money center bank under our control as your Qualified Intermediary, however, you are named as account owner(s) and interest goes to you.
Is the money taxed? No, not by either the Federal or state (or city) governments if the funds are spent within 180 days on Replacement Property as selected by you anywhere in the U.S. and if other rules are followed.