Postponing the Investor's Tax Bill
There are a lot of Washingtonians, including residents of suburban Maryland and Virginia, who bought real estate many years ago that has dramatically appreciated in value. Now, for a number of reasons, some of them want to sell.
If your home is your principal residence, there is a great tax benefit available when you sell. If you are married and file a joint income tax return, and have owned and lived in the house for at least two years of the five years before it is sold, you can exclude up to $500,000 of any profit you have made. If you are single (or are married and file a separate tax return), the exclusion is limited to $250,000.
But if the property is considered an investment -- which means you don't live in it and most likely are renting it out -- you cannot take advantage of that exclusion. If you sell investment property and have owned it for more than a year, you have to pay capital gains tax. Currently, the federal tax is 15 percent of your gain, and you will have to pay any applicable state or local tax, as well. If you haven't owned for one full year, you will be taxed at ordinary income rates.
There is one way to avoid having to pay the tax now, and that is to do a 1031 exchange. Before we explore this legal avenue, two caveats must be raised. First, this exchange is available only for investment properties; you cannot do an exchange and defer any tax on your personal residence. Second, contrary to popular opinion, a 1031 exchange is not a "tax-free" exchange. If you follow the rules, you defer -- not avoid -- paying any capital gains tax.
We call this a 1031 exchange because it is authorized under Section 1031 of the Internal Revenue Code. This law allows an investor to exchange one property for another and not have to pay capital gains tax immediately. It is often referred to as a "Starker exchange," named after a man who years ago won a significant court case that allowed him to obtain the exchanged property several years after he sold his original property.
If you are considering an exchange and want to sound professional, you have to use the proper terminology. The property you currently own is the "relinquished property" and the new property is the "replacement property."
There are many rules that must be followed religiously. While it really looks like you are selling the relinquished property and buying the replacement property, if you adhere to the process, the IRS will consider the transaction to be a valid exchange, and no tax will be assessed against you.
You ask: I thought we always have to pay taxes; isn't this tax avoidance? Not really. Here's a simple example: You bought the property many years ago for $100,000 and it is now worth $500,000. Let's say the replacement property will cost $600,000. But, because of the exchange, for tax purposes, the tax basis (original cost plus improvements) of the new property is the basis of the relinquished property. This means that when you ultimately sell the new property, all of the tax that you deferred will now have to be paid.
Here are some more rules you have to follow:
-- When you go to settlement on the relinquished property, all of the net sales proceeds must be put in escrow with a "qualified intermediary." This can be a professional company, a bank or an attorney who has not represented you in the past two years. One important fact: You cannot have any control over those sales proceeds.