No one likes writing Uncle Sam large checks. Yet many people needlessly send Uncle 15% of their profit when they sell a rental house or land. There is a simple way to avoid it. It’s called a 1031 exchange and it can keep you from losing tens or hundreds of thousands of dollars in unnecessary taxes and loss of growth.
The 1031 exchange is named after section 1031 of the IRS tax code. Basically, it allows you to exchange an existing investment property for a different investment property without having to pay capital gains taxes on the transaction. This applies to any investment property including rental houses, raw land, business property, commercial real estate, condos, apartments, etc.
You can roll the profit from the sale of an existing property into the purchase of the next. Not only does this save you from having to pay capital gains taxes in the short-term, it can also preserve the ability of appreciated property to receive a step-up in basis at death which can eliminate those taxes altogether.
For instance, I recently talked with a retiree who lives in Ohio and owns a rental house in Florida. The recent hurricanes have increased the management headaches. He’s looking to simplify his life and wants to sell, but a sale would result in a large capital gains tax bill. With a 1031 exchange, he can sell the Florida rental house and reinvest the proceeds by purchasing a portion of a professionally-managed property. That way he can still earn the income without all the management headaches-and avoid paying capital gains taxes in the process.
As with all IRS tax code, there are a number of provisions and details that must be met exactly for the exchange to be valid. First of all, the exchange has to be a ‘like-kind’ exchange. For instance, you can’t sell a rental house and reinvest the money into a U.S. Treasury bond. Investment real estate to investment real estate is considered a like-kind exchange even if it is a rental house for a potion of a shopping center.
Second, there are several important time periods that must be followed. From the time ownership of the first property is transferred, you have 45 days to identify the replacement property and 180 days to complete the replacement property’s purchase. Since real estate closings are notorious for hiccups, I recommend you have two or three properties identified prior to the transfer of the property you are selling. Also, try to close on the purchased property well before the 180 days. If you miss these deadlines, you lose the 1031 exchange ability.
Another important provision is that you cannot take possession of the proceeds of the sale. A qualified intermediary is used to hold the funds, handle the paperwork and make sure the law’s provisions are carefully followed. One of my clients worked with a local attorney and used escrow services at the local bank to fulfill these provisions.
Since all the proceeds of a sale are rolled into the new property, a 1031 exchange allows you to continue to get income and growth off the money otherwise sent to the IRS. The client above saved over $125,000 in immediate capital gains taxes. If they are getting a 10% return, that results in earning an additional $12,500 each year. Those extra earnings add up quickly and can help provide additional retirement income.
Lastly, you can add money to the purchase of the replacement property or even reinvest just a portion of the sales proceeds. The IRS rules regarding such situations are complex, but essentially, if you end up getting any proceeds of the sale they are subject to at least some capital gains tax.
A 1031 exchange is not for everyone but can make a tremendous difference in the right situation. If you own investment property and are considering selling it, I recommend exploring your options of doing a 1031 exchange. Talk with an advisor, CPA or attorney who is familiar with 1031 exchanges. Not all of them are, so make sure you are working with one who has handled this type of transaction.