Since property values are going up some of you might be considering selling and taking profits on your properties. If the property you are considering selling is NOT your personal residence and qualifies as an investment property then the option is available to sell by taking advantage of IRS tax code section 1031. This is the tax code that allows investors to defer paying capital gains taxes when selling investment properties. This procedure is referred to as a “1031 tax free exchange”.
Under current tax laws the capital gains tax rate for selling investment property is taxed at a rate of 15%. The tax rate for capital gains is lower than most marginal tax rates, so it would be beneficial to take advantage of selling using a 1031 tax free exchange to get immediate tax savings.
There is a catch as there so often is with tax laws exceptions. The catch is that you can’t get your profits in cash, but you are allowed to roll over your profits into another investment property that you MUST purchase within 180 days.
If you don’t “need the money now” then rolling your profits into a replacement property will add to your net worth by saving taxes now and should allow for greater appreciation of the property purchased.
One other reason to do a 1031 tax free exchange is that the IRS calculates a 3% depreciation amount for every year an investment property is owned. This amount is “re-captured” at the time of sale by being added back into the property’s cost basis and taxed at the taxpayer’s marginal tax rate. Taking advantage of selling using a 1031 tax free exchange will also allow for the taxation of IRS depreciation to be rolled into the replacement property.
Under IRS tax code 1031 a tax fee exchange is treated as an exchange and not as a sale. This is an important distinction since selling is always treated as a “taxable event”.
It is this unique distinction that allows for any profits also known as capital gains to be transferred into the replacement property. It is VERY important that each requirement of tax code 1031 be followed very carefully as the devil is in the details, since if all requirements are not followed the exchange can be rejected and the “sale” will then be subject to capital gains taxes in the year of sale.
A few things need to be explained or defined prior to going any further:
Capital Gains: Taxable profits from an investment property
Like Kind Property: Property qualifying to be included in a 1031 tax free exchange must be considered like kind. In the world of real estate all real estate is considered like kind.
Replacement Property: This is the property that is purchased.
Accommodator: Company or third party that accepts and controls the net money from the sale of the property sold while the 1031 tax free exchange is in process.
Boot: Any sum of money received by the seller of a property in a 1031 tax free exchange. The amount of money received is taxable at the taxpayer’s marginal tax rate.
Recaptured depreciation: This is the taxable event that is triggered upon the sale of investment property when depreciation is added back to the cost basis of the property. The IRS 3% annual depreciation calculation is added back at the time of sale and taxed at the tax payer’s marginal tax rate.
“3” Property Rule: This is the rule that states that no more than 3 potential replacement properties can be identified to the IRS in any 1031 tax free exchange.
The general requirements of an IRS 1031 tax free exchange are:
- The property must be an investment property
- The replacement property much be like kind
- The replacement property much be of equal or greater value
- The seller is prevented from receiving the net cash proceeds
- The funds much be handled by a third party, known as an accommodator
- The replacement property much be identified within 45 days
- The purchase of the replacement property must close within 180 days
There are applications in the law that allow for “partial tax free exchanges”. Under this situation the percentage of cash received under the law is referred to as ‘Boot”. In partial tax free exchanges the proportional percentage of cash received from sale of the property will be subject to the recapture of property depreciation and becomes a taxable event in the year the property is sold.
There are companies known as accommodators that can be retained to perform the duties of handling the funds, filing required forms and completing paperwork required to finalize an IRS 1031 tax free exchange. There are companies that only act as accommodators. There are also escrow companies that provide accommodation services in addition to standard escrow services.
It is very important that any accommodator you chose to handle your transaction needs to have adequate insurance and fidelity bonds to guard against misappropriation of your money while in their custody. There are many reputable companies that can professionally handle an IRS 1031 tax free exchange.
There are reasons other than tax deferment to consider when selling by way of an IRS 1031 tax free exchange. Some things to also consider are:
- Relinquishment of management duties: The options exists to exchange into a managed real estate investment where monthly management duties are handed by a management company or by a general partner or some other management arrangement.
- Exchange into a triple net property: Where management duties, costs and expenses relating to property ownership are transferred to the tenant occupying the property.
- Exchanging multiple properties: It is permissible to exchange numerous properties into one replacement property thus reducing multiple management duties required when owning more than one property.
With tax rates high and possibly going higher in the near future it only makes sense if you are considering selling to take advantage of IRS 1031 and defer taxes now. In a future Blog we will be discussing tax advantages available when selling a personal residence.