Hawaii has a very high percentage of rental properties, as you might imagine. From small Waikiki condos up to multi million dollar beachfront homes, rental properties abound on Oahu. Since many owners would like to sell their properties and cash in the gain, avoiding the huge capital gains tax is an important issue to understand.

One way to avoid taxes, or at least delay them, is through a 1031 exchange. A 1031 exchange allows you to exchange Hawaii real estate

property for a like-kind, so that no gain is realized and no tax is paid on the sale. In an exchange, a property owner sells one

or more properties, let's say a rental condo in Ala Moana, for one or more replacement properties of like-kind, let's say a rental single family house in Montana, deferring the payment of federal taxes and some state taxes. Since the property is sold without the owner actually

receiving any money, there is no tax paid at that time.

This is very popular in Hawaii and it has helped thousands of people avoid or delay taxes. But someday when the property is sold without an exchange, the owner may be subject to tax. Unless of course the person moves into the house and lives in it for a few years, long enough to satisfy the new IRS rules. 

There are many many rules for 1031 exchanges that must be followed. Before you sell your Waikiki rental condo and put an offer on a Hawaii Kai single family home, make sure you understand the 1031 rules, and work with a Realtor who understands them even better than you do. A small mistake can cost you thousands of dollars in taxes!

First you have to find an intermediary, or an accommodator, who makes sure that the rules are followed and that no money is taxable. Title and escrow companies can act as intermediaries, and here in Hawaii I recommend First American accommodation for this service. The accommodator holds the money, watches the timelines, and makes sure the funds are dispersed correctly. There are many other companies here in Oahu who perform this service, so you should check around and get the best service.

In an exchange, timing is everything, so you must identify and inform an intermediary before you sell your investment property. After the sale of your property, the IRS gives you 45 days to identify the property you want to buy with your profits and 180 days to complete that transaction. You may identify up to three properties within the 45-day period. 

The disadvantages of a 1031 exchange include a reduced cost basis for depreciation in the new property. The tax basis of replacement property will be the purchase price of the replacement property minus the deferred gain on the relinquished property. So the replacement property includes a deferred gain that will be taxed in the future when the house is sold without an exchange.

RULES

The Replacement Property's Title Must Be Taken In The Same Way As The Relinquished Property. If a husband and wife own property in joint tenancy or as tenants in common, the replacement property must be deeded to both spouses, either as joint tenants or as tenants in common. 

The Replacement Property Must Be Like-Kind. Like-kind replacement property means any real estate held for income, investment or business use. A house in Manoa can be replaced with vacant land in Kailua, as long as both are for investment. Land in Kaneohe can be replaced with a condo in Waikiki. 

One property can be exchanged for two or more properties. Two or more properties can be exchanged for one replacement property, and as long as the new property is worth more than the old one by at least $1, there will be no tax. Investment property can be exchanged for business property. 

However, a personal residence cannot be exchanged for anything. 

Any Boot (gain, money) received will be taxable. This is okay when the seller is willing to pay some taxes. Otherwise, boot should be avoided in order for a 1031 Exchange to be completely tax-free.