Vail Daily column: Delay paying taxes on investment properties, for free
Now that property values are up the upswing, many people who own investment properties are finding opportunities to sell property they have owned for years and buy something new. They are also finding that they face a large taxable capital gain liability.
What many people do not realize is that they are often paying tens of thousands of dollars in capital gains taxes needlessly, even though they have often paid high prices for some expert tax advice. The key to avoiding taxes when you sell a property may be to use what is known as a 1031 exchange. The problem is that many experts are not familiar with the rules of 1031 exchanges. They really are sweepingly broad and can be applied to many types of transactions.
A 1031 exchange does not cancel taxes, except in one very unique set of circumstances, but it can delay paying them for many years, or decades. This allows you to effectually borrow investment capital interest-free from the government. There are some strict rules that must be followed, and these only apply to investment properties but second homes that have been rented and depreciated are eligible for exchanges as they are deemed to be investment properties on the borrowers tax returns if they show taxable income and deductible expenses.
The biggest public misconception about exchanges is that they must be just that, an exchange. This is not true; you do not have to convince the seller of the property you want that he needs to own, for example, your gas station in Los Angeles. You can sell the building in L.A. to whomever will buy it and still do an exchange to acquire a nice property elsewhere.
In brief, the way an exchange works is that you put your property up for sale and when you find a buyer you include as part of the contract that you wish to structure this as a 1031 exchange. You then retain the services of a qualified intermediary to handle the exchange. There are several companies that do this in Colorado.
Holding in escrow
The intermediary receives the proceeds of the sale and holds them in escrow. You must than identify a property by the 45th day after the sale closes that you wish to acquire and notify the intermediary. From there you have up to 180 days from the date of the sale to close on the new property.
The new property must have a value equal to or greater than the property being sold. It is not enough that the equity be equal. There are also strict rules about debt relief. If you had a mortgage on the old property, then you must either bring all or part of that amount in cash to the new closing or take out a equal or greater mortgage as part of the new property acquisition.
If you need some of your equity from the old property out in cash, there are ways to do it but you will be taxed on that part of the equity you withdraw, but that may still save you huge amounts on your current year’s tax bill by deferring taxes on the entire gain.
One of the most common misconceptions is that 1031 exchanges must be for exactly like-kind real estate. Many advisors think this means a commercial building for a commercial building or a resort condo for a resort condo. The courts and the IRS have settled on real estate for real estate as being like kind. So if you owned a gas station in L.A. and wished to buy a rental property or some vacant land here you could do a 1031 exchange and defer the taxes.
Thus if you have landlord burnout from managing your commercial property and would rather own a nice condo that you and your family can use for vacations and rent out the rest of the time, then you can do a 1031 exchange.
Keep great records
One thing about a 1031 exchange is you need to maintain meticulous records, sometimes for decades. If you continually roll over one 1031 exchange into another, then someday you will calculate the taxable gains from each transaction, and that could mean locating records from the first exchange forward in the event of an audit. Also, be sure these records are clear enough that your heirs or your executor can locate and decipher them in the event your estate ends up holding your last acquisition.
And there is one way that you might actually wipe out capital gains taxes using a 1031 exchange. If you have a second home you have rented out or other residential rental property, you can do an exchange for a new residential property that just might work for your next primary residence. If you then rent out the new property for at least a year and then move into it as a primary residence and live there for a minimum of four more years, then you can sell the property and claim the accrued capital gains under the primary residence capital gains exclusion, which is $250,000 for an individual or $500,000 for a married couple. You can claim this exclusion multiple times in your life so it can be a great strategy if you have accrued a large amount of capital gains rolling over investment properties.
There are some and outs to putting together the financing on your new property using a 1031 exchange, so be sure you have a lender who is familiar with the procedures. The rules and interpretations from the IRS can change frequently, so be sure and get good professional advice about your specific scenario.
Chris Neuswanger is a loan originator at Macro Financial Group in Avon and may be reached at 970-748-0342. He welcomes mortgage related inquiries from readers. His blog and a collection of his columns may be found at http://www.mtnmortgageguy.com.