Real estate markets have rebounded to near pre-recession levels. This is good news, but as property values increase, so do potential taxable gains that would be realized when selling property. Capital gain taxation is getting more complex and could include these four components:
- Federal capital gain taxes at up to 20%, plus
- Medicare surtax on net investment income at 3.8%, plus
- State taxes at your state tax rate (up to 13.3% for California), plus
- Depreciation recapture at 25%
Investors looking for ways to minimize these taxes are making tax-deferred exchanges popular again. IRC Section 1031 allows taxpayers to sell business or investment property, reinvest the proceeds in a new property, and defer all capital gain taxes that would have been due, but only if strict guidelines are followed. A taxpayer cannot simply sell one property and buy another.
Section 1031 exchanges are commonly called like-kind exchanges or tax-deferred exchanges. They are also incorrectly referred to as tax-free exchanges.
The property you are exchanging must be business or investment property. Stocks, notes, and partnership interests are specifically excluded and do not qualify. Property held for sale also does not qualify. This means if you are flipping real estate you will not be able to take advantage of tax-deferred exchanges since the property would have been purchased with the intent to sell.
Both the relinquished and replacement properties must be similar enough to qualify as “like-kind.” Like-kind property is property of the same nature, character or class.
Find a Qualified Intermediary
You will need a qualified intermediary (QI), also called an exchange facilitator, to help guide you through the process and to receive the proceeds of the sale. It is very important for a QI to receive sale proceeds, since you must not have control of the funds at any time. If you receive or are in control of the proceeds at any time, the exchange will lose its tax-free status.
You have 45 days from the sale of your property to identify the replacement property. The identification must be made in writing to your QI. You must then acquire (actually close escrow on) the replacement property within 180 days from the sale of your property.
You can exchange your property for more than one replacement property. You can identify up to three replacement properties of any fair market value, as long as you ultimately close on those properties. (The three property rule)
Alternately, you may identify an unlimited number of replacement properties as long as the market value of all properties does not exceed 200% of the fair market value of the relinquished property. (The 200% rule) This allows for the possibility that one or more properties may not actually close escrow.
Reinvest all Proceeds
In order to be completely tax-deferred, all of the proceeds from the sale of your property must be invested in the replacement property or properties. If there is unused cash remaining after the exchange closes, this will trigger some of the gain to be taxable currently. It is possible to have both deferred and current recognized gain in the same exchange.
Reducing mortgage debt is the same as receiving cash and will result in a portion of the sale being taxed currently. Example: You relinquish a property with a mortgage of $800,000, and receive a property with a mortgage of $750,000. All proceeds were used, so no cash will be distributed to you, but your debt was reduced by $50,000, resulting in a gain taxable in the current year.
The rules involving 1031 exchanges are complex and the stakes can be high. Make sure that your exchange is a smooth one by working closely with your advisors and consulting with a qualified intermediary as early as possible in the process.