July 5, 2012

Defer Investment Real Estate Taxes with 1031 Exchange

Normally when you sell a rental property the profit from the sale will incur a capital gains tax bill.   Right now long term capital gains are 15% but are normally higher.   In addition you may also owe depreciation recapture taxes.   Selling a rental can incur a hefty tax bill.    Thankfully there is a way to defer that tax bill if you are trading up and buying another rental property.   A 1031 exchange can be used to defer the tax liability if you are selling one rental property and buying another rental property.

What is a 1031 Exchange?

The 1031 exchange is basically an exchange of one property for another as defined by the IRS.  This maneuver allows you to defer the taxes if you obey the rules of the 1031 exchange.   1031 Exchange is basically just the name for the process you use to satisfy the tax regulations in order to make the property exchange and defer the taxes.   You might think of a 1031 exchange as a 'tax loop hole' but its not really a loophole, its a specific procedure defined by the IRS.   I like to think of it more like an IRA rollover.  

Why do a 1031 exchange?

Using a 1031 exchange will allow you to defer your tax bill when you sell one rental and obtain another.   If you want to sell a rental and cash out then a 1031 doesn't apply.   If you want to 'trade up' from one rental to another than a 1031 will let you delay the tax bill.  


What property qualifies?

You can not do a 1031 exchange on property that is your primary residence or that you intend to immediately resell.   The exchange has to be between 'like kind' property which basically includes any real estate in the US.    But you can trade any rental for any other rental OR any combination of rentals.    You could sell a house and buy a duplex or sell two duplexes and buy a four plex.  

How do you do a 1031 Exchange?

In order to perform a 1031 exchange you MUST have a 'qualified intermediary' (QI) handle the exchange.    The QI is a bonded professional who acts as an intermediary and holds the money during the exchange process.   Use of a QI is required by the IRS and its not optional.  THeres no way around using a QI and they have to be independent.   

You also need to perform the exchange within specific time period.   You have 45 days after the sale of the original property to identify the replacement and 180 days total to complete the exchange. 
These dates are rigid in general and you need to be careful to make sure you get the exchange done within the limited time period.


In order to defer all the taxes the value, debt and equity in the replacement property should each be more than or equal to the original property.   In other words you can't take a house with $100,000 market value and a $50,000 loan and then trade it for a $50,000 house you own outright.   Why?   Cause you're effectively using $50,000 of proceeds to wipe out that $50,0000 loan and you are realizing the gain so you'd owe taxes on that $50,000 amount.    On the other hand you could go the other direction and exchange a home you own outright worth $50,000 for a new property worth $100,000 and a $50,000 mortgage.  

The basic steps outlining a 1031 exchange would be

1. Identify a Realtor who knows how to do 1031 exchanges.
2. Identified a qualified intermediary to handle the exchange
3. Sell your original property, then the money goes into an account handled by the QI
4. Within 45 days of step 3 you need to then identify a replacement property
5. Buy the replacement property within 180 days of step 3, the money then comes out of the account held by the QI.
6. Record the exchange in form 8824 and include it when file your income taxes with the IRS for the year the 1031 exchange took place


How much does a 1031 exchange cost?

The 1031 exchange process is not free.   You will have to compensate the qualified intermediary.  I found one website advertising 1031's for $495 and another source indicated that costs generally range from $400 up to $1000.    The QI may also keep all or a portion of the interest earned on the exchange proceeds while the exchange is taking place.  

When should you NOT do a 1031 exchange?

There are a few situations where a 1031 wouldn't make sense: 

No tax bill : Right now the capital gains rate for people in the 10% or 15% is actually 0%.   So if you're in the 10% or 15% income tax brackets you can sell capital gains and pay $0 in taxes.    Another situation where you wouldn't have a tax bill is if you are taking a LOSS on the property.  That is not so uncommon nowadays with so many properties underwater.
Tax bill lower than 1031 fees: If you have a marginal gain and a small tax bill then it wouldn't make sense to pay someone a fee to do a 1031 exchange to defer that tax bill.   For example say you bought a property in 2003 for $90,000 and its now worth $93,000.  You have a gain of $3000 and a tax bill of 15%.  Thats a $450 tax bill.  It wouldn't make sense to pay a QI $500 to $1000 to avoid a $450 tax bill.
You don't want another rental : You wouldn't want to do a 1031 exchange if you aren't looking to trade up to another rental. 
You can't sell & buy fast enough : If you don't have any expectation that you can get it done within the required 45 / 180 day time frame then  you may not want to attempt a 1031. 


1031 Exchange resources

Theres a ton of information on the web for 1031's.   Some useful sites are listed below:



Federation of Exchange Accommodators -- this is the industry group for the qualified intermediaries.   You can use their website to locate QI's in your area.   They also have a lot of info on 1031's and an FAQ.
Field Guide to 1031 Exchanges from National Association of Realtors  -- They have a ton of links to various articles and resources on 1031's.
IRS publication 544 : Sales and Other Dispositions of Assets -- This is the general publication that includes sales of assets and covers the like kind transactions.

Instructions for form 8824 and Form 8824 -- the tax form you file with the IRS to record the 1031.

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2 comments:

  1. Sounds like you're looking to 1031? What are you thinking of buying, if that's the case?

    I live in the absurdly overvalued (even now, imo) Inner Bay Area but I'm eyeing some properties on the periphery and in other states where I have friends and/or family. Interesting times... maybe interesting enough for me to become a landlord.

    ReplyDelete
  2. Question...I did a 1031 exchange on a property in 2008. If I sold the property now and sold it for the same amount less real estate fees do I have to pay capital gains because I didn't pat capital gains in the First transaction in 2008?

    ReplyDelete

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