An investment property owner selling a property can potentially owe up to four different taxes: deprecation recapture of 25 percent, federal capital gains of either 15 or 20 percent depending on taxable income, 3.8 percent net investment income tax when applicable, and state tax (as high as an additional 13.3 percent in California).
IRC (Internal Revenue Code) Section 1031 refers to the 1031-tax-deferred exchange, which provides the investor with a way to delay paying these taxes by exchanging an investment property for another.
The 1031-tax-deferred exchange is quite common; however, there are a few forgotten rules many investors overlook.
The timeline starts when you close on the relinquished property
You will have 180 days to complete the exchange after you close escrow on the relinquished property (the property you are selling). However, you are required to identify the potential replacement properties within the first 45 days.
A purchase agreement needs to include specific language
The sales contract will need to include specific language whether buying or selling a property. One provision is that the sales contract can be assigned to the exchange accommodator.
Should hold an investment property for one year
As part of an exchange, a property needs to be held as an investment to qualify for an exchange. The IRS makes no indication how long a safe holding period may be to qualify automatically, but in asking a tax advisor many say at least one year.
Selling a rental house and buying an office building qualifies
The IRS requires you to exchange like-kind property. What this means is exchanging a property held for investment for another property held for investment. If you own four single-family rental houses, you could exchange these into one commercial office building.
Foreign investors subject to a 15 percent withholding
Foreign investors are subject to a 15 percent FIRPTA (Foreign Investment in Real Property Tax Act of 1980) withholding applied to the sale of a property unless they have a withholding certificate.
Purchasing your replacement property first
The transaction is more complex and does cost more in fees, but you could buy the replacement property before you sell your relinquished property. This is called a reverse exchange and has its own set of rules that must be strictly followed.
Keeping some of your equity from the sale
You do not need to use all of your equity in acquiring the replacement property, but any amount that is not reinvested in a replacement property of equal or greater value will be taxed as “boot.” Keep in mind that if you have a loan on the relinquished property your replacement property must have a loan as well of equal or greater value or you could also be taxed on the difference.
Moving into a property you originally purchased as an exchange
You exchange into a rental house and later decide to move into it as your principal residence. The IRS will look at your original intent and how long you held as an investment property. However, it possibly could be done.
Please check with your tax advisor before performing an exchange or doing any of the above.
Burt M. Polson, CCIM, is an active commercial real estate broker. Reach him at 707-254-8000, or [email protected] Sign up for his email newsletter at BurtPolson.com.