Recently, a family of my acquaintance were selling a condo that had been an investment property. They had owned it for five years, and it fetched a rent a third higher than the mortgage; however, it was in an old building that had had several expensive assessments, so the condo had not been cash-flow positive during that time. Plus, the property had nearly doubled in value, and the couple thought it was prudent to cash out, since prices in the area seemed to be softening. They started researching their options.
There are three reasons people like investing in real estate. First, it’s a great way to diversify a portfolio and build wealth. Second, average citizens can take out a mortgage to leverage their investment; this is a more exotic, less advisable option when it comes to securities. Finally, a piece of real estate can pay off in two ways: by appreciating in price and by bringing in rental income.
When spouses filing jointly sell their primary residence, $500,000 in gains is shielded from tax. But when you sell an investment property, as my friends were doing, you owe capital gains tax on the proceeds. This can take a big bite — the federal top rate is 20 percent.
However, there is a way to defer paying that tax. It’s called a 1031 exchange. It allows you to put off capital gains tax if you use the proceeds of the sale to buy other rental real estate.
Here’s what my friends found out:
In order to complete a 1031 exchange, you must engage the services of a firm that specializes in such exchanges before you close on the sale of your investment property. They will charge a fee to hold onto the money from the sale until you are ready to spend it.
After closing, you have 45 days to identify up to three “like kind” properties for the exchange. Like kind simply means real estate; in practice it can be anything from empty land to an apartment or a freestanding house. But it must be an investment property, not a timeshare, shares in a REIT, or a second home, and not renovations or improvements, either.
And, you have 180 days in total — or until tax day (with extensions) for the year your property was sold, whichever comes sooner — to close on the sale of one of those three properties. For example, if you closed January 1, 2018, the new property must be purchased by July 1. But if you closed in December 2017, you only have until April 15 of 2018, unless you get an extension on your taxes.
Now let’s do some math.
In order to get the full tax deferral, the value of the new property should be equal to or greater than the sale price of the old property. Keep in mind that you owe capital gains on the mortgage payoff, as well as the cash that comes from the sale of your original property. You can, of course, put some cash into a new property and keep the rest, known as “boot.” But in practice, if you go much below the sale price the tax advantage can be quickly eaten up by closing costs and fees. As a rule of thumb, if the boot, the amount you take home, is greater than the total capital gains, it’s not recommended to do an exchange.
The main issue that wards people off of 1031 exchanges is the time crunch on finding a suitable new property. It can be daunting if real estate is not your primary occupation. It would be best to research your options before putting your existing property on the market. In fact, you can do a “reverse exchange” by buying the new property before selling the old property — provided you are confident of selling it in time.