Rental properties have many great benefits including favorable tax benefits with the IRS. Not only can you depreciate rental properties to save on taxes, but a 1031 exchange allows you to sell a rental property and defer the taxes on any profit you make or recaptured depreciation. A 1031 exchange has many rules and regulations and you have to make sure you complete the exchange correctly to avoid a large tax bill from the IRS. I am not an accountant or an attorney, please consult your attorney or accountant for any specific tax or legal advice.
What are the basics of a 1031 exchange?
A 1031 exchange allows an investor to sell one or more investments and buy new investments without paying taxes on the gain. 1031 exchanges can be tricky and complicated, so always talk to an accountant or lawyer when completing one! Here are the basic guidelines:
- You can sell one property and replace it with one or more properties
- The new properties must be worth at least as much as the property you sold (if you sold a house for $200,000, the new properties must be bought for at least $200,000).
- Any cash you receive from the sale of properties would have to be used to buy the new properties.
- An intermediary has to hold all the cash from the sales until it is used for the new purchases.
- You do not pay taxes on the recapture of deprecation, but your depreciation schedule does not start over. If you depreciate $50,000 off the structure of a property, that $50,000 would carry over to the new property. If the value of the new structure was $100,000, you could only depreciate $50,000 of it.
How are taxes avoided?
A 1031 exchange is a real estate transaction that involves two like properties; one being sold and one being bought within a certain time frame. There are many restrictions on a 1031 exchange and the IRS is not perfectly clear when describing the restrictions. Some basic principles are the properties must be held at least a year, be used for business, the replacement property must be identified in 45 days and bought in 180 days. If all of these requirements are met and a few others, a rental property can be sold without paying any taxes on the profit or recaptured depreciation.
What taxes would be owed in a normal sale?
When you sell a rental property, you have to pay taxes on any profit you make. You also may have to pay recaptured depreciation on a rental property. The IRS allows you to depreciate a rental property because they feel the structure has a limited life span and decreases in value every year. You can deduct that depreciated amount from your taxes every year, which is a huge advantage to owning rental properties. However, if you sell the rental property for more than what the depreciated value is, you will have to pay back those taxes you saved.
Residential rental property is usually on a 27.5-year depreciation schedule and commercial rental properties on a 39-year schedule. Each year you deprecate 1/27.5th of a residential rental or .0363636363636364%. You also only depreciate the structure of the property, so if you had a $100,000 property with a lot value of $10,000, you would figure depreciation on the $90,000 value of the structure. Each year you would depreciate $3,272.
When you complete a 1031 exchange, you can sell the depreciated property without paying taxes on the profit or depreciation. When you buy the new property you still have the same depreciation schedule (it does not start over).
Here is an example:
- Property is bought for $100,000 and the structure is worth $90,000.
- Over ten years more than $32,000 is depreciated from the home. That money can be deducted from your income on your taxes.
- If you sell the house for $100,000, the $32,000 would show as recaptured depreciation on your taxes, and you would pay taxes on it.
- You pay ordinary income tax on the depreciated income maxed out at 25% plus the 3.8% net investment income tax, if applicable, not at capital gains rates.
If you make a profit on the property; buy for $100,000 and sell for $200,000 you would pay taxes on the profit at the long-term capital gains rate. That rate is either 15% or 20% based on your income. You could end up paying $20,000 to $30,000 in taxes after selling the rental property without doing a 1031 exchange.
- $32,000 times 25% = $8,000
- $100,000 times 20% = $20,000
- Total $28,000
Do you have to depreciate a property?
Yes. You cannot choose to not depreciate the property as the IRS makes you take the deductions.
What properties are eligible?
The IRS has determined that many forms of real estate can be used for a 1031 exchange including any property used for a business which includes a store, manufacturing facility or office building. Investment property can also be used for a 1031 exchange, which includes rental properties. It has even been determined that water rights and mineral rights qualify for a 1031 exchange. These cannot be used for a 1031 exchange:
Stock in trade or other property held primarily for sale
Stocks, bonds, or notes
Other securities or evidences of indebtedness or interest
Interests in a partnership (we will discuss later a major exception to this one)
Certificates of trust or beneficial interests
A Chose in action (a right to something, such as payment of a debt or damages for injury, that can be recovered in a lawsuit)
Can house flips be used?
The IRS has determined fix and flips cannot be used for a 1031 exchange unless you meet certain guidelines. The IRS does not want real estate investors who fix and flip constantly to be able to use a 1031 exchange to defer taxes. If you only fix and flip occasionally and meet these guidelines you may be able to use a 1031 exchange.
1. The flip must be rented out for at least one year after it is repaired.
2. The home cannot be sold until after it has been rented at least one year and should not be listed before being rented for a year.
The problem with this strategy is the IRS does not say you have to hold a flip one year to do an exchange. The IRS simply says a flip list shall be held for an acceptable amount of time, and it is up to the accountant and investor to determine if their transaction qualifies. Some people have determined that to be a year, but if the IRS thinks you are a professional house flipper trying to cheat them out of money, you still may get in trouble.
Others say you only need to own the property one year for it to qualify, not to have it rented for a year. talk to professionals to figure out what strategy you want to use.
How do you complete the exchange?
When completing a 1031 exchange a qualified intermediary must be used by the investor to oversee that transaction. The IRS does not tell you who can be an intermediary, only that these people cannot be one:
The TP’s attorney
The TP’s CPA
The TP’s real estate agent
Any relative of the TP
Any employee of the TP
Any business associate of the TP
The intermediary holds the funds after one property is sold in the 1031 exchange and uses that money to buy the new replacement property. When doing a 1031 exchange, the owner must identify the property he is exchanging and declare it before the sale. Once the subject property is sold, the investor has 45 days to identify a new property to exchange with the old property. Once the new property is identified the investor has 180 days to close on the new property.
How is the money handled?
When selling a property and buying a new property in a 1031 exchange, the investor must use all the cash from the sale of his property to buy the new property to avoid paying taxes. The new property must cost at least as much as the sale price of the old property to avoid paying taxes as well. If the investor does not use all the cash from the sale of his old property or buys a cheaper property, he may have to pay taxes on the unused cash or price difference in the properties.
The reason the investor has to buy a property that is just as expensive as the property he sold is that liabilities must be considered. If you sell a house for $200,000 that has a $100,000 loan and exchange it into a $100,000 house, you still had a gain. You used all of the cash from the first sale to buy the second house, but you also had $100,000 of debt that was paid off. That paid off debt can be considered a gain.
How is the title taken?
When doing a 1031 exchange, the investor must take title to the new property in the same name as he owned the property being replaced.
You also cannot use a 1031 exchange to sell a property to someone you are related to.
Can you use exchange money for repairs?
You cannot use exchange money to make repairs after a property has been purchased. It would be outside the exchange and could make the transaction taxable. If you plan to make repairs to a property that you are buying in an exchange you need to have the seller make the repairs before closing and raise the price to account for the repairs. If that is not an option, you may have to use other funds to make repairs that are not from the exchange.
What is a Reverse 1031 exchange?
Most investors will sell a property they own and then purchase a replacement property. It is possible to buy the replacement property and then sell your original property. This can be a difficult maneuver because the investor will not have the cash from the sale of his original property to buy the new property.
It may make sense for an investor who is building a replacement property to exchange into it. It may take more time to build and buy a property than 180 days, and that is why an investor would do a reverse exchange. This is appropriate for large companies exchanging manufacturing facilities or other unique buildings that must be built to spec and are not available on the market.
How can you get your money back out?
One way to get the cash out of a rental property you exchange into is to refinance the replacement property. You may have $100,000 in cash proceeds from a rental property you are exchanging. That money can be used to buy a replacement property in a 1031 exchange, but that is a lot of money to have locked up. If you refinance the property after buying it, you can take out some of that cash without paying taxes on it. The government does not consider money from a refinance profit.
Can you use a personal residence?
It used to be possible to complete a 1031 exchange into a personal residence. Exchange a property into a house that you would like to live in at some point. The replacement house must be rented for at least a year after the exchange is completed. Once that year is up, move into the replacement house and live there for at least two years. Since you are living in the home for at least 2 out of 5 years as a personal residence your profit could be tax-free!
I have heard that the IRS has tried to limit this type of transaction so talk to your accountant!
Why I did not complete a 1031 exchange on my rentals
I recently sold two of my rental properties (number 5 and 13). I was thinking about completing a 1031 exchange when I sold those rentals, but I ended selling them and keeping the cash. There are a few reasons why I decided not to do a 1031 exchange, and most of them had to do with not being rushed into buying a replacement property. When you do a 1031 exchange you have 45 days to identify a replacement property or properties, and you have to buy properties that are at least as much as what you sold your previous property for. Since I am not buying rental properties in Colorado at this time, that means I would have to find replacement properties in a new market, with a new lender, and have very little time to do it. I will have to pay more taxes by not completing a 1031 exchange, but that doesn’t mean I will not be in as good of a financial position. By rushing to buy new properties, I may not purchase as good of a deal or may not learn a market as well as I would like before investing.
There are a lot of intricacies and details in the IRS tax code that must be adhered to when completing a 1031 exchange. There are more types of 1031 exchanges and many more situations that investors will run into. Talk to an accountant or attorney to make sure you are following all the guidelines.