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Let's say you have an investment property that you purchased for $50,000, that you have made no other improvements and that it's now worth $750,000. If you sell it for cash, out right, you'd have to pay capital gains tax on $700,000.

It's my understanding that for your principal residence you can get a tax break on up to $250,000 (if you're single) or $500,000 (if you're married) on capital gains but idk that that applies to investment property. And even if it did you'd still owe capital gains taxes on $150,000 so the question still stands.

Anyway, my question is... if you do a like-property exchange for another property worth $750,000 can you turn around and immediately sell the newly acquired property for that much without paying capital gains at all?

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The like kind (aka Section 1038) exchange is only for investment properties.

I supose one might take their house, convert to rental, and years later exchange it, but the $500K exclusion gets lost in that process.

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  • I wasn't sure if that'd apply but that was a bit of an aside. It'd affect the amount of capital gains tax you had to pay but it wouldn't change the fact that capital gains tax was owed. My question was more about if you could flip an investment property to avoid paying capital gains taxes.
    – neubert
    Aug 17, 2015 at 14:18
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    The exchange gives you a new property with a basis that is adjusted for that gain. i.e. a new property with basis $X lower than your purchase price. It doesn't ever go away, just delayed. In a perfect world, you die, leave it to your kids at a stepped up basis, but stay below the $5M estate tax issue.
    – JTP - Apologise to Monica ♦
    Aug 17, 2015 at 14:28
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I know you didn't ask this, but it really should be addressed:

Can you immediately sell the new property?

No. A 1031 Like Kind Exchange only applies to investment property. "An exchange of real property held primarily for sale does not qualify." I can guess what you're thinking: "I bought it low and sold it high, that's an investment, right?" Nope.

If you buy a candy bar for $1, put it on a shelf, and then sell it for $2, then the candy bar was inventory (not an investment). And you ask "Then what is an investment?" The shelf was an investment. Your business made money by having it, not by selling it.

For a property to be an investment, your business needs to make money by having it (not just by selling it, which would make it inventory). That generally means renting the property out. "How long does it need to rent?" Uh... make that a separate question.

Can you sell the new investment property without a capital gain?

No. In a 1031 Like Kind Exchange, the cost basis transfers to the new property. In your example, the investment property still gained $700,000 (sale price $750,000 minus cost basis $50,000) and you would have a capital gain of that amount.

Note that the cost basis does change for other reasons ignored here, for example, depreciation.

Can you avoid the tax on a capital gain?

Yes! If you live there for 2 years (and other rules here) then the sale of your home at a gain would not incur capital gains tax (up to the amounts you noted).

So... What's the plan?

  1. Buy it low value
  2. Rent it out for a year
  3. Increase it's value
  4. Like kind exchange it for something with higher value
  5. Rent it out for a year
  6. (optionally, goto step 3)
  7. Live in it for two years
  8. Sell it
  9. Profit
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