We recently discussed how depreciation serves as a non-cash deduction, which delays income taxes due. However, there is more good news for those that have sold an investment property for a gain. The IRS allows for certain property exchanges that can kick tax payments even further down the road.
What is the exchange?
You can exchange your property for a similar property. This is called a Section 1031 Exchange, or simply a 1031 tax exchange. While you typically have to pay a capital gains tax when you sell your investment property, this allows you to postpone it. It is particularly useful for real estate since the provision cannot be used for certain other investments such as stocks and bonds.
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There are some conditions, of course. First, you have to use the proceeds to invest in a similar property. This seems tricky, but you should not get hung up on the terminology which can prevent you from doing a 1031 exchange. The IRS takes a wide view on the subject, generally considering real property to be similar, as long as both are in the United States. Those restricting real estate investment to New York City should be fine.
The IRS will also want to see that you have not sold the property and invested in another one. This would trigger a taxable event. If you simply switch one property for another, that would qualify. But, this can get more complex. You can defer the exchange, providing you meet the IRS requirements. For instance, the agency will want to see that the entire transaction is linked and cannot stand on its own. You also have 45 days from when you sell the property to designate (in writing) the replacement property you are going to buy. You also have to close on the new property within six months.
Keep in mind; the exchange only applies to investment property. You cannot use the 1031 exchange rule on your personal home, or even your secondary/vacation property.
You feel pretty good after selling your investment property for a $1 million gain. However, there is a top long-term capital gains rate of 20% if you held it for more than one year. In 2016, this kicks in if you are in the 39.6% tax bracket, which means your income was $470,701 or above for those married and filing jointly. After you figure out how much you owe in taxes, you might feel a little glum. If you don’t do the exchange, you owe $200,000 in capital gains taxes. But, that is not all. Since you took advantage of depreciation, the IRS expects this amount to be recaptured. Suppose you have expensed $100,000 in depreciation over the years. Uncle Sam expects you to pay 25% of this amount, or $25,000 ($100,000 multiplied by 25%). This works out to a tax bill of $225,000.
You decide to engage in a 1031 exchange. You find a suitable property within 45 days and close within six months. Assuming this is a delayed exchange, you need an intermediary to hold the cash from the sale.
If you receive any cash (i.e. after you swap properties, the one you gave away was worth more, so you get cash), this part of the transaction is taxed immediately as a capital gain. To avoid this, buy a property that is worth at least as much as your old one.
This was a simple example. However, you also need to consider your mortgage. If you had a $500,000 mortgage, but the new mortgage is $400,000, that $100,000 is considered a gain. To avoid this, buy an apartment worth at least as much as your old one and carry the same or greater mortgage.
There are also reverse exchanges. This is where you buy the replacement property before “selling” yours. However, these are not practical since you buy the property with all-cash, but banks may be reluctant to lend.