Managing real estate investments in California is fraught with difficulties. Having to worry about tax liability while you are dodging legislative hurdles – rent control, local government planning commissions, and short-term eviction bans – counters most wealth-building strategies. While we can help with those issues too, this article is focused on capital gains tax relief. Particularly how not to get burned by taxes when closing out a real estate position with a 1031 Exchange.
What is a 1031 Exchange?
This transaction gets its name from section 1031 of the Internal Revenue Code and is essentially a tax break. Figuratively speaking, a 1031 Exchange is the swapping of one real estate investment for another. In the process, the profit from the sale of your property is not treated as a normal capital gain. The sale of real estate would normally be susceptible to capital gains tax if the sale price was greater than the adjusted purchase price and no exclusion applied. One common exclusion, for example, exists whereby married couples filing jointly may exclude up to $500,000 in profit from the sale of their home. Specific requirements exist, such as ownership by one or both spouses, residential use, and only one such sale in two years.
If you think you might be able to take advantage of this exclusion, please speak with us and we can answer any of your questions.
How is a 1031 Exchange conducted?
Generally, people will use a delayed exchange, where a middleman will take possession of the net sale proceeds after you sell your property. If you take possession of the cash, it will negate the beneficial tax treatment. She will use the proceeds (and other assets of yours, if necessary) to buy the exchanged property, in essence swapping the property for you. In this type of delayed exchange, you have to meet a strict timeline. Once you sell the property, you have 45 days to designate in writing the property that you want to buy. You can select three properties, as long as when you close, one of those three is chosen. Under certain limited conditions, you can designate more than three.
The Heat is On – the 180 Day Rule
Once you sell your property, the replacement that you are buying must be closed within 180 days. Combined with the 45-day designation rule, some parties have a hard time achieving this purchase in a timely manner and fail the process, resulting in capital gains liability. This can be more common in a down market, or where purchase conditions are difficult.
Just to give an example of a section 1031 situation, let us say Jane owns an apartment building that she can sell for one million dollars, and she paid $500,000 for it. If she sold it, she would owe capital gains tax on $500,000, minus any lawful write-downs. She could benefit from depreciation recapture. For example, if she depreciated the building by $75,000 for wear and tear, that would normally be treated by the IRS as decreasing her cost basis, so that it would be $425,000, subjecting her to extra capital gains tax.
However, with section 1031, the cost basis is rolled over to the new property. Without section 1031, Jane would have to pay off the note, pay capital gains tax, and may not be left with much value. She could instead, however, buy another building. If she buys a building with less value, and there is cash leftover, this is the “boot.” This will generally be taxed. If she has a smaller mortgage on the new acquisition than the sold property, the “gain” will also be classified as boot and thus taxable.
What are the requirements of a 1031 Exchange?
You have significant time constraints. The IRS wants you to finish the transaction within 180 days. The properties have to be business or investment-oriented. The IRS must see the properties being exchanged as like-kind properties for the tax to be deferred. Like-kind is not a literal requirement, and vacant land can be swapped for an apartment building, for example. There are no limits to how often you can use this benefit, as long as you meet the section’s strict requirements.
What are the downsides to a 1031 Exchange?
You are essentially deferring your tax liability, not extinguishing it. When you purchase your new property, the basis for taxes when you sell it includes the capital gain from the predecessor purchase. You cannot take advantage of this benefit, as a general rule, on your private residence. There are exceptions, as is often the case with the tax code. If you rent your house out for around two years – the code is not clear on the minimum amount of time that it considers “reasonable” – it is converted into a business investment and is no longer your primary residence. Another downside is that 1031 Exchange benefits no longer apply to personal property, such as airplanes, although the legislation that changed that, the Tax Cuts and Jobs Act (TCJA), could provide benefits that offset that loss.
Because this is a tax deferral, your great success in trading up properties will lead to greater and greater capital gains. One way to avoid paying the capital gains tax on that highly appreciated real estate investment is to bequeath it to your heirs. The IRS will not look to collect capital gains tax upon your death. Your heirs will receive the property at the market rate, not the price that was paid.
Avoiding tax liability is our personal and professional ambition
It is too often the case that hard-earned money is lost to taxes. Our lawyers and staff have a personal interest in lowering tax liability and treat this mission professionally. Our law firm has counseled many clients on these and other essential matters. We are happy to assist by answering your questions, providing legal advice, and examining your real estate structure and goals. Call the trusted attorneys at Lowthorp, Richards, McMillan, Miller & Templeman at (805) 981-8555 or fill out our online contact form. We operate primarily in the Tri-Counties area – Ventura, Santa Barbara, and San Luis Obispo.