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Investing in real estate can be a great way to reduce your taxes. If you play your cards right, you can deduct expenses while renting apartments to tenants or leasing a warehouse to a business. You also may be able to claim depreciation deductions for wear and tear on the building, eventually recouping most of the money you put into a property. In some cases, you even can deduct annual tax losses.

But there's a day of tax reckoning when you sell the building. Assuming it has appreciated in value since you acquired it, you'll have a significant capital gain. If you've held the property for a year or less, your gain will taxed at high rates for ordinary income. And even with a long-term gain, you may be taxed at a rate as high as 20%.

Fortunately, though, you can postpone the tax hit on a real estate sale indefinitely by arranging a like-kind exchange of properties instead of selling a building directly. If you meet the requirements under Section 1031 of the tax code, and the accompanying regulations, your gain will be tax-deferred.

Caution: There are special risks associated with real estate investments, including 1031 exchanges. This includes substantial fees and expenses and strict timing limits. If the transaction isn't properly constructed and executed in a timely manner, an investor may lose all tax benefits of such a transaction, including depreciation recapture.

4 Key Principles

First, a like-kind exchange only works for investment or business properties. None of the properties involved in the exchange can be a personal residence.

Second, all the properties must be "like-kind." But this isn't as limiting as you might think because the IRS takes a liberal view. For instance, you can give up raw land and obtain an apartment building in return or vice versa.

Third, you may not be able to defer all of the taxes. To the extent you receive something other than another property in the exchange—"boot," in real estate jargon—you'll be taxed on the gain you realize. Typically, boot is cash, but it also might be represented by a reduced mortgage principal. Of course, if you're the one giving the boot, you don't owe any tax on it, but it increases your basis in the property.

Fourth, there's an additional 3.8% surtax on "net investment income" to consider in real estate transactions that applies to some high-income investors. While a direct sale of real estate could trigger or increase the surtax, you aren't liable for this add-on in a like-kind exchange, except to the extent that there's boot.

Idea In Action

Suppose you acquired a business building 20 years ago for $500,000 and it's now worth $1.5 million. If you sell the building outright this year, you would have a $1 million long-term capital gain. Assuming the entire amount is subject to the 20% capital gain rate and the 3.8% surtax, you would owe $238,000 in tax on the sale. However, if you swap the property as part of a Section 1031 exchange without receiving any boot, your tax bill is zero.

It's often difficult to find someone who owns property that you want who also wants to acquire your property in a swap. That's why most like-kind exchanges involve multiple parties. Depending on your situation, you also may enlist the services of a "qualified intermediary" to help facilitate an exchange.

Timing Is Everything

To qualify for tax deferral under Section 1031, you have to meet two deadlines:

1. You must identify or receive the replacement property within 45 days of transferring legal ownership of the relinquished property.

2. You must receive title to the replacement property within 180 days or the due date of your tax return, plus extensions, for the tax year of the transfer, whichever is earlier.

The 180-day period begins on the date legal ownership of the relinquished property is transferred. If that period straddles two tax years, it might be cut short by the tax return due date. For instance, if you transfer ownership on December 15 of this year, you only have until the tax return due date to obtain the title. But a tax filing extension can trigger the 180-day limit.

Finally, be aware that Section 1031 exchanges could be targeted in future tax reforms. However, until that happens, this can be a good way to reduce potential taxes on real estate sales.