Q: Several years ago you gave me valuable information on a 1031 exchange. Now I need information on how long I have to keep the properties I purchased with my 1031 exchange funds. Is the law the same as if I purchased the property straight out? It has been two years since I purchased the property. Is the long-term capital gain still the same?
A: Your timing couldn’t have been better, and when it comes to 1031 exchanges, timing is everything.
When you own investment properties and decide to sell them, you ordinarily would have to pay tax on the profits on the sale. However, a provision in the Internal Revenue Service Code allows those owners to sell a property and defer the payment of capital gains and other taxes. The tax provision is Section 1031 of the tax code, and the practice is generally referred to as a 1031 exchange, a Starker trust or a tax-deferred exchange.
Here's how it works. First, you find a tax-deferred intermediary to help you out (also called 1031 exchange companies). At the closing of the property you're selling, you'd set up the exchange documents and deposit all of the proceeds from the sale of the property into a special account the 1031 exchange company has set up.
From that point you’d have up to 45 days to find and designate the new investment property you plan to buy; the value would have to be at least the same or greater than the old property. After that, you’d have no more than 180 days from the sale date to close on that new property. Again, there are other rules and some of the timing requirements can be shortened. What you can’t do is blow the 45/180 day rules.
If you do it right, you'd now own a new investment property and would not have any taxes to pay on the sale of the old property until you decide to sell this new property down the line. But, if you again decide to use a tax-deferred exchange, you can continue to defer the payment of taxes on each sale. Usually, you have to keep the new property for two years, although some practitioners may say that the minimum time that you must hold the replacement property is only one year. The IRS rules may differ depending on the circumstances and the reason for the sale.
Having said all that, there's now something brand-new to consider. You should also know that you can sell that investment property and invest the capital gains in a Qualified Opportunity Fund. The Tax Cuts and Jobs Act that passed on Dec. 22, 2017 created Opportunity Zones. You invest in these Opportunity Zones through a Qualified Opportunity Fund. We mention all of this because some real estate investors may wind up switching from using 1031 exchanges and investing in these Qualified Opportunity Funds.
There are some huge benefits with a Qualified Opportunity Fund that differ greatly from 1031 exchanges for real estate investors. For one, with a 1031 exchange you defer the payment of real estate taxes, but in Qualified Opportunity Funds you get to avoid paying taxes altogether.
The tax rules that will govern these Qualified Opportunity Funds are still being finalized as we end 2018, and Opportunity Zones (the Treasury has certified 8,700 Opportunity Zones, which is 12 percent of U.S. Census tracts) and investing in Qualified Opportunity Funds won’t be for everyone. But let’s say you’re planning on selling an investment property that went up in value extensively over the year. If you sell that property, you have to transfer all of the funds from the sold property to the new property.
The Opportunity Zone rules only require you to invest the capital gains from the sale of the old property. So if your sale nets you $500,000 and half of that came from capital gains, you’d end up with $250,000 in your pocket and $250,000 to invest in an Opportunity Zone.
Next, once you invest in an Opportunity Zone, the tax rules appear to give you the ability to avoid paying tax on any new capital gains you make from the new investment in the Opportunity Zones. In some cases, if you continue your investment, you don't pay taxes on gains for 10 years or more.
Furthermore, if you don't happen to be a real estate investor and you have capital gains from other investments, you are not restricted to capital gains from the sale of real estate; those capital gains can come into play from the sale of other assets that give you a capital gain.
In addition, if you have real estate, you might end up avoiding a tax bill on the recapture of any depreciation you took while owning the new Opportunity Zone property. So in real estate terms, you can keep some of your non-capital-gains cash from the sale of your old property, you can invest your capital gains from that sale, you can delay paying tax on those capital gains, you can avoid paying taxes on future gains that you might make on your investments in the Opportunity Zones, and you might avoid paying tax on any depreciation you take on the Opportunity Zone property investment.
It almost sounds too good to be true. And all these benefits may still get throttled back. The rules and regulations that came out recently were around 70 pages long. All in all, if you have money and have capital gains, the tax law gives you the ability to put that money to use in certain designated areas and you can make money with the money that’s invested there and not pay taxes for 10 or more years.
And just in case this wasn't a sweet enough deal, the IRS rules allow you to increase your cost basis by up to 15 percent. That means that on your old investment, you can exclude taxes up to 15 percent on the old investment.
We’ll continue to watch the development of Opportunity Zones and Opportunity Funds, and let you know what happens. In the meantime, because it’s such a new thing, find yourself a supersmart accountant or enrolled agent to help you make the wise choice.
Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact them through her website, ThinkGlink.com.