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Tax-deferred exchanges can make selling easier.

Like many North Shore homeowners, you may have seen a tremendous jump in your second vacation home property value over the past ten years. While we’re now experiencing a market correction, prices are still strong and many investors find themselves selling a home that has greatly increased in value, putting them in the position of facing a large capital gains tax bill after the closing.

If you’re thinking of selling a second vacation home or investment property, but are concerned about the capital-gains tax, a tax-deferred exchange might be a good alternative for you. Thanks to the IRS tax code section 1031, it’s possible to sell your current property and make a new investment while deferring all capital gains taxes. By deferring the tax, you are making more of your money available to invest in another property. Section 1031 recognizes that a property owner who has reinvested the sale proceeds into another property has not realized a cash gain that would generate the funds to pay tax. In other words, a property owner is not forced to pay tax on a paper gain.

As long as both the property to be sold and the property to be purchased are held for investment purposes, you are free to purchase whatever “like kind” of property you want. For example, a taxpayer can sell a single-family rental and exchange it for an apartment building.

You may complete a partial exchange to take some of the money out to pay off other bills, but you will incur a tax liability on this portion. You can also buy a replacement property for a lesser amount and put cash in your pocket, but you’ll be liable for some taxes, albeit a smaller amount.

From the day you close on the sold property, you have only 45 calendar days to identify the property you intend to purchase and 180 calendar days (or the due date for your tax return – whichever is earlier) to complete the acquisition of those properties. No extensions are allowed on the 45-day deadline, so ideally you will have been working with your Realtor to identify potential properties to buy, and will have all your ducks in a row.

Remember, the exchange is tax-deferred, not tax-free. When the replacement property is sold, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. Eventually the exchange property can be converted to your primary residence or a vacation home, but at that point, you will be liable for the deferred taxes. Should the exchanger die while still holding the replacement property, heirs receive the property at the current market value and no one is liable for the tax deferment. Therefore, exchanging can be an excellent estate planning tool.

A key player in this process is a “qualified intermediary,” or QI. The IRS disqualifies any person or entity from acting as an intermediary if that individual has had a business relationship with the taxpayer within the past two years. A QI is an independent party who facilitates tax-deferred exchanges. The QI actually acquires the relinquished property and transfers it to the buyer. The QI holds the sales proceeds, acquires the replacement property, and transfers it to the taxpayer to complete the exchange. In this way, the IRS does not consider that the taxpayer are ever in receipt of the funds.

Tax-deferred exchanges are complicated, and it’s crucial to understand all their nuances. You don’t want to overlook an investment opportunity because you don’t understand the broad definition of “like-kind”. Consult with a CPA, financial advisor, tax attorney, accountant, or other advisor to determine if a 1031 exchange is the right choice for you.

Ellen Higgins is a REALTOR® and certified buyer’s agent who works at Realty by the Sea, LLC in Beverly Farms ( ).