Real estate investment can be rewarding: Don't forget about capital gains come sale time
When buying an investment property, it can be easy to think about the rewards. The steady rental income, the investment portfolio growth, and the payout when it comes time to sell the property. It can be even easier to forget, or ignore, that investment properties are taxed with capital gains at the time of sale.
Currently, for individuals who are married and filing jointly with taxable income between $80,000 and $496,600, the capital gains tax rate is 15%. For individuals who are married and filing jointly taxable income is $496,600 or more, the capital gains rate increases to 20%. For individuals looking to dispose of investment properties and promptly reinvest in other real estate, an effective method of capital gains tax deferral may be a 1031 exchange.
What is a 1031 exchange?
1031 Exchange is a tax deferral strategy under IRS section 1031, providing a temporary tax exemption on any gains from the sale of business or investment property.
To qualify for a 1031 exchange, the seller must earn a profit on their sale, and use these proceeds to purchase a qualifying like-kind property for the same or greater value of their sale. Below is a comparison of two families selling similar rental properties and earning a profit of $500,000.00. The key difference is the Smiths are engaging in a 1031 exchange, and the Millers are pursuing a traditional sale:
Joe & Mary Smith - 1031 Exchange | Mike & Jane Miller - Traditional Sale |
Gross Proceeds: $500,000.00 | Gross Proceeds: $500,000.00 |
Capital Gains Taxes: $0 | Capital Gains Taxes: $100,000.00 |
Net Proceeds: $500,000.00 | Net Proceeds: $400,000.00 |
In this example, the Smiths would not pay any capital gains taxes and would be able to use the full $500,000.00 towards a like-kind investment property of the same or greater value, while the Millers would only have $400,000.00 remaining after paying 20% capital gains taxes.
Who's eligible?
Any taxpaying entity may set up a 1031 exchange on any investment or business properties. These taxpaying entities may include individuals, trusts, corporations, and limited liability companies.
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What is a like-kind property?
Most real estate, if used for the same purpose, is considered like-kind. For example, if used for rental purposes, the IRS considers vacant land to be like-kind to improved residential real estate. The IRS does not consider US property to be like-kind to properties in other countries, even if the intended use is the same. The IRS also specifically excludes the following types of property from 1031 exchanges: inventory or stock in trade, partnership interest, or certificates of trust.
Executing different exchanges
There are three types of 1031 exchanges: a simultaneous swap, a deferred exchange, and a reverse exchange. There are two key deadlines when completing a 1031 exchange, though the exact timeframe may vary depending on the type of exchange.
The first deadline for a simultaneous swap or deferred exchange is 45 days from the date the original property sells, at which point the seller must have identified a potential replacement property. The identification must be in writing, signed by the seller and delivered to the seller of the replacement property or a qualified intermediary. This written notification deadline is key, as is who receives delivery of such notice. The IRS lists several individuals who are party to the transaction, but to whom service of this written notice is considered insufficient.
The second deadline is no later than 180 days after the sales contract for the exchanged property has been executed. By this deadline, the replacement property must be received, and the exchange must be complete. In a reverse exchange, where the seller has identified a replacement property before selling or even listing their original property, additional rules and regulations come into play, making it easier to end up in an unexpected situation with taxable gains.
For taxpayers engaging in a 1031 exchange, using a qualified exchange facilitator, and working with a knowledgeable closing team, will help ensure compliance with IRS rules and additional rules provided in the income tax regulations.
Stephen J. Lacey, JD, LLM, is a member of the law firm Lacey Lyons Rezanka. His practice areas focus on estate planning, probate, and real estate.
This article originally appeared on Florida Today: If you're investing in real estate, read up on 1031 exchanges
