The words "tax" and "defer" often appear in the same sentence because no one is eager to give a portion of their earnings or gains to the Internal Revenue Service. In many cases, it's impossible to avoid, but the Internal Revenue Code includes special provisions for capital gains tax. In fact, it's possible to defer capital gains tax indefinitely, according to Exeter 1031 Exchange Services, but you won't have the use or enjoyment of your profits. You must keep rolling them over.
Do a 1031 Exchange
The steps involved in setting up a tax-deferred or 1031 exchange of property – named after Section 1031 of the IRC – aren't complicated, at least by themselves. When you sell an asset or property, you must roll the proceeds over into a like-kind investment. For example, if you sell real estate, you must replace it with another real estate investment. If you sell stocks, you must buy more stocks. It's that simple, but certain time frames and guidelines apply.
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- Within 45 days of closing on the sale of your original property, find a like-kind, qualifying property you want to purchase.
- Clearly describe and identify the property in writing. Sign and date the statement.
- Close on your new property within 180 days of the sale of the original property, or by the date your tax return is due, including an extension, whichever comes first.
Use a Qualified Intermediary
You can minimize chances of an error or a dispute with the IRS by using the services of a Qualified Intermediary. The Intermediary must be approved by the IRS. He'll document the new investment you intend to buy when you identify it and hold the proceeds from the original sale until you close on the replacement property. The IRS has strict rules that a 1031 exchange must actually be an exchange. You can't take the proceeds from the sale, use the money for other purposes, then buy or finance another property 180 days later. There must be a clear and direct paper trail for the money from one transaction to the next, according to 1031 Corporation Exchange Professionals.
Another option is to literally exchange property with someone else with no money changing hands – you and the other party simultaneously exchange deeds or titles to ownership or enter into an exchange agreement expressing these terms.
Set Up a Private Annuity Trust
If you can't find a suitable new property within 45 days, you have another option. You can create a private annuity trust. This won't defer capital gains tax indefinitely, however, and you'll probably need professional legal help to set up the trust. You can transfer the property into the trust, then take payments from it in an income stream over a period of years, just as you would if you had purchased an annuity. You won't be taxed on the sale of the property, but you'll have to pay taxes on the incremental payments you receive.