Are Selling your investment property or real estate asset now and want to avoid/defer paying income taxes on all that profit? Thanks to the tax code, there is a legal way to push that issue down the road. Select another property to buy and have the profits from your sale moved to the new property.
The like-kind exchange (1031 exchange) is a tax deferral method approved by the Internal Revenue Service for investment purposes. You will eventually have to pay capital gains taxes when you sell the real property at a later date.
The 1031 exchange program has been in place for many years. This program has permitted investors to grow their wealth using the taxes that would otherwise be paid as an interest-free loan. When you sell that apartment building and earn $100,000 in profit, you will owe capital gains tax on it. Rather than pay that tax and call it a day, you can do a tax-deferred exchange meaning investing in a new apartment building or a like-kind property.
No taxes due until…
There are specific rules to follow such as using an exchange facilitator approved by the IRS to receive the funds from the sale, hold them and transfer them to the new property.
Your taxable gain will occur when you sell the second property years later. If you wish to repeat the process for another future acquisition, you can continue to push out the tax burden. An exchange provides you with interest free money to finance your next venture. The exchange process is fairly simple but it can become complicated and that is why you hire a tax advisor and a professional 1031 exchange facilitator.
Contact the exchange facilitator at the time you decide to sell your original property. The escrow company/closing attorney will communicate with the 1031 facilitator to be sure you do not receive the proceeds of your sale.
Your CPA will explain the taxable income that is being deferred and any capital gains tax liability involved. You need the cooperation of the seller of your exchange property by informing them the exchange proceeds will be used for the purchase.
I just completed a 1031 exchange
Some property owners may not want to wait for the sale of their first property to conclude. This is the challenge, trying to make sure the sale proceeds come to the new purchase promptly. I just went through this process of selling rental property. The buyer of a property that I was selling wanted to do a like-kind purchase of my property.
His real estate agent told me that the buyer’s property was on the market and should sell so we set up a 60-day contract. As the seller of the property, I was not in a hurry since I was receiving rental income.
The buyer was able to sell and close on the original property within 30 days. The amount of time it took to make the 1031 exchange into the new escrow deal with my property was a couple of days. The transaction was closed shortly after the exchange funds arrived. A very smooth transaction on my part as the property seller.
In my case, I decided to pass on a delayed exchange for tax planning purposes. Had I wanted to buy another property, I would have contacted a facilitator, located a property, and done exactly what my buyer did.
Many variables to consider with an exchange
These types of exchanges can get complicated in part because they can be like a daisy chain. You decide to sell and buy a similar investment meeting the requirements of the Internal Revenue Code Section 1031. The property is located and an offer is made contingent on the sale of the investment property I own. As it happens the person selling me the property also wants to buy a property using the same process.
They make a contingent offer. I have seen these get stacked up four high. When the first of the dominoes fall, the others close in rapid succession or not. The entire chain can collapse if one participant fails to close.
Before I explain the basic rules of the 1031 exchange, you should know that Congress and the Biden administration made an effort to remove the 1031 exchange program altogether in one of their massive giveaway bills. Fortunately, there were enough votes on the right side (get the pun) to stop it. We nearly lost the ability to manage our businesses for profit.
Yes, you are using what is effectively taxpayers’ funds to grow your business BUT, later on, the tax bill will be paid and the taxpayers will reap their reward. In theory, the amount of profit you will pay will be much greater, therefore, paying back the taxpayers for the use of their money. Win-win.
Real estate investors need to create an exit strategy for every property they acquire. Part of that strategy is the consideration of an exchange transaction. It’s important to plan for the sale of a property. There are time limits which we will discuss below for completing the purchase transaction.
Basic transaction
Your rental property is offered for sale at $500,000. The buyer agrees to pay you $500,000 with closing scheduled for 45 days from the contract date. After all expenses for the sale including paying off the mortgage and paying your portion of closing costs, the net to you will be $300,000.
You have already selected an exchange accommodation titleholder to work on your behalf. Start the process of looking around for a property to purchase with the exchange funds. You know that you will have $300,000 to work with as a downpayment and closing costs. You must however buy a similar property or like-kind.
The day before closing, you find a property that fits your budget and meets the exchange requirements. You make an offer. Shortly after closing the 1031 exchange facilitator provides a portion of your funds to the buyer as an earnest money deposit. Since you have already identified a property you will have 180 days to close from the date your original property sold.
Your new property is purchased for $600,000 and the entire $300,000 from the first transaction is put down on the new property. You will have a first mortgage of about $300,000 (less closing costs). The property closes within 45 days well within 180 days.
This is how the process is supposed to work. The problem is that the sale of the property may be complicated and therefore funds are not available to make an offer. In some cases, the investor can not locate a property and the clock is ticking. I have seen investors so desperate they will overpay for the property or buy something that is not what they want.
Debt requirements
If the initial property you sold has a mortgage, for example, $200,000 that will be paid off. The new property must have a mortgage of at least $200,000 to qualify. If you purchase a new property with a lower mortgage, the difference will be considered “boot” and will be taxable.
If you purchased a new property with a mortgage of $150,000 and the old mortgage was $200,000 you will be taxed on the difference of $50,000 even if the entire amount from the sale is transferred by the regulations.
Timing
Within 45 days of the sale of your property, you must designate a replacement property in writing to your intermediary. You must close on the new property within 180 days of the close of the original sale. The 45 days you have before you name an exchange will eat into your 180 days. For example, you sold your apartment building on August 1. You have until September 15 to designate a new property.
If you wait until the last day to designate a property, you will only have 135 days left to close on that property. It seems on the surface that this is a sufficient period but on occasion, it is not. Failure to meet the deadlines voids your ability to take advantage of the program.
As I mentioned above, planning will help solve these timing issues but can not eliminate them. You should be looking around for a suitable property before you list your property. Secure an interest from a seller through your real estate agent to work with your 1031. You can write an offer for a longer closing date and put down a deposit to hold the property. Then move forward with your sale.
Potential tax implications
The 1031 exchange rules require 100% of the funds from the sale to be incorporated into the new purchase. If you take even one dollar from the proceeds, you will be subject to tax on that dollar and any other dollars you accept. The funds must go directly to the intermediary however after 180 days, the intermediary can issue any excess funds which will be subject to tax. Those funds are called “boots”.
You sold your apartment complex for $500,000. The purchase only requires $400,000. The intermediary will be able to release the remaining $100,000 at the end of the 180 days. The $100,000 is subject to income tax.
You must seek professional help from a CPA when preparing your tax return. The IRS requires you to submit form 8824 with your tax return in the year of the exchange. All of the details of the exchange are required on that form. The adjusted basis of the property will be included and your CPA can help you with that.
Depreciation recapture
Recapture of depreciation is something that your CPA can work with you on. You take the purchase price of your property and divide it between the building and land to arrive at the property value. You purchased a property for $300,000. The building represents 75% of the value of the purchase or $225,000. Divide this amount by 27.5 years for an annual depreciation of $8,181.
You are entitled to deduct from the profits of the current property the total annual depreciation of $8,181. You held the property for 10 years for a total accumulated depreciation of $81,181. When you sell the property the IRS wants to recapture most of that amount.
The 1031 exchange will push that time off until the last property is sold. The $81,181 attaches to the initial property and is added to the total accumulated depreciation from the new property. So what is this all about? Essentially you receive an interest-free loan from the taxpayers for delaying taxes through depreciation. The concept is based on the fact that the property gets old and requires maintenance.
If you earned a net of $10,000 after expenses in a year from rent on that property, you would deduct the $8,181 from the $10,000 for taxable income of $1,819. You have temporarily avoided paying tax on most of your net income. When you sell the property later, you will be taxed on the deferred amount again, allowing a free loan.
Vacation homes could be an issue
You purchased a vacation home to use as a retreat. Later, you have decided to rent it when you are not there. You have effectively turned your home into a business assuming you are being paid for real rent. A sale of this property should qualify for a 1031 exchange on another vacation property used for income purposes. This area of the law can get sticky. If you want to do a 1031 exchange on a vacation home it is a good idea to work with a CPA on the tax consequences.
What makes vacation homes and even your principal residence a challenge is the determination of what is income property and what is our principal residence. This gets into other areas of tax law where lots of people either because they are unaware or intentionally try to avoid taxes using semantics.
Some tips
How do I get cash out of a transaction without that amount being subject to income tax now?
Several months before you intend to sell your property, refinance the property and pull out cash or obtain second mortgage. When you sell the property, the sale proceeds will pay off the mortgage debt. The remainder will move to the new property.
In effect, you did not take any money from the transaction so you did not trigger a tax event. Later when you settle up with the IRS on the sale of that new property. The amount you retained from the refinancing will be subject to taxes down the road.
As with all good things, this process may one day go away so before you do it be sure to check with your CPA. Just for purposes of how it may look, try not to refinance in the same year when you do the 1031 exchange, just a bit of caution.
Can I do a 1031 with my personal residence that I rented?
There is a method to make this work but there are rules and you must comply with them. Check with your CPA to determine if they will work for you.
Can I use a 1031 exchange for estate planning
Yes, an exchange is a great way to push out the tax burden into the future. The property can become part of your estate and there are some major benefits if you pass away and your heirs become the new owners. This is an area where your attorney is best suited to explain how it works.
Read more about residential rental investing at this site. Try this article, 13 ways to finance rental property in a recession. If you paid a contractor more than $600 in the year to maintain your property, you must report that payment to the IRS, read more about it here
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