The Internal Revenue Service (IRS) allows an investor to sell investment real estate and potentially pay no taxes. Using a well-known tax law called Section 1031 of the Internal Revenue Code (IRC) an investor could defer capital gains on certain real estate investments.
Without a 1031 exchange tax liability could be as high as a blended rate of up to 35 percent in California. An investor who decides to cash-out from a sale could end up paying a large tax bill.
The tax rates
At the federal level, the capital gains tax rate is either 15 or 20 percent depending on your income. Also, you could be obligated to pay a 3.8 percent Net Investment Income Tax (better known as the new Medicare tax).
Depreciation recapture is one of the highest and most commonly overlooked taxes. The depreciation recapture tax is 25 percent of the total depreciation you have taken on the improvements of your property over the life of your ownership.
If you live in California, where we have the highest capital gains tax in the country, you will end up paying between 9.3 and 13.3 percent depending on your income.
Four basic requirements
The IRS does not allow any leeway in these requirements. You must strictly adhere to the rules or end up paying some or all of the tax due plus interest and penalties if your exchange does not qualify.
First, the properties must qualify. The IRC states the properties involved in the exchange must be of like-kind. Many misinterpret this as the IRS loosely defines like-kind as property held for business, trade or investment.
So, you could exchange a single-family rental house for a commercial multi-tenant office building for example.
Second, you must complete your exchange within 180 days. From the close-of-escrow of the relinquished property (the one you are selling), you are allowed 180 days to close on the replacement property (the new purchase).
Third, you are required to identify your potential replacement properties within the first 45 days of the exchange. You have two methods of identifying the replacement properties in the identification letter to the IRS: the three property rule or the 200 percent rule.
Fourth, for total tax deferral the following three guidelines must be equal to or greater:
– The net purchase price versus the net sale price
– The net equity in the replacement property versus the relinquished property
– The debt in the replacement property versus the relinquished property some of which can be replaced by placing cash into the exchange.
Using the 1031 exchange to repeatedly “sell” your current investment property and “buy” a new investment is an excellent strategy for increasing your net worth while deferring taxes.
In essence, if you were to bequeath your investment property to your heirs you could eliminate any tax liability through a stepped-up basis.
While books and seminars are offered on the subject, you will find this to be a brief primer of the 1031 exchange. This is a complex tax code that can easily be misinterpreted. Be sure to consult with a qualified tax professional as well as a qualified intermediary before any decision making.
Burt M. Polson, CCIM, is a local real estate broker specializing in commercial, luxury estates and wineries. Reach him at 707-254-8000, or [email protected] Sign up for his email newsletter at BurtPolson.com.