Capital Gains Loopholes: The Mighty 1031 Exchange

In order to avoid paying capital gains taxes, it is helpful to know and take advantage of the so-called ‘loopholes’ in the tax code. One of the most useful is called the 1031 Exchange or alternately the Starker Trust Exchange.

It works likes this; if you inherit and then sell a vacation, rental, or other investment home your parents owned, you have to pay taxes on the appreciation of the home from the time it was first purchased.

This can be a huge amount particularly if the property was purchased in what was once a rural area, and is now a bustling suburb. Combine that with normal upgrades, the occasional renovation, and a home purchased in cash for $45,000 forty years ago can legitimately be worth a million dollars today in many areas of the country.

In addition, $955,000 is a lot of money to pay taxes on — it approaches $200,000 at current capital gains tax rates but the Starker Trust Exchange gives you an option to avoid that. If you turn around and purchase a home that is worth as much or just over what you earned by selling your parents’ home, you can avoid the tax man altogether.

However, there is a strict time limit on the exchange — so strict that the IRS requires you to obtain a Qualified Intermediary (QI) to facilitate the transactions. You have only 45 days from the date of the initial homes’ sale to provide your QI with a list of at least three homes you would consider purchasing with the money. At that point, the QI begins working with you and the owners of the prospective properties and you have only an additional 135 more days to complete the sale entirely.

At no point in this process does the money from the initial sale of your parent’s home ever belong to you. Instead, it goes directly from your parents’ estate into the hands of the QI, who acts as an escrow agent holding it until the sale is complete. This is to keep you from investing the money and delaying the transaction in order to earn more interest on the money.

The 1031 exchange allows you to upgrade from the property you inherited to another investment property, while at the same time avoiding paying a substantial amount of capital gains taxes to Uncle Sam.

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