It’s a seller’s market out there now for real estate. I know of a number of sellers who have received multiple offers on their real estate. For most people, when you sell your home, you will not have to pay any income or capital gains taxes on the sale so long as you have owned and used it as your principal residence for two of the last five years before the sale. In that situation, you can exclude up to $250,000 of the gain if you are single and up to $500,000 if you are married filing joint.
But what if the property you have decided to sell is rental or other business or investment property you have owned for years? You have been holding off selling because you have fully depreciated it. When you do sell it, the proceeds will mostly be taxable gain. Is there something that you can do?
Absolutely. Structured properly, you can sell that rental or other business or investment property and do not have to immediately pay taxes on the gain. However, you do have to jump through some hoops. Generally, you can delay paying the taxes on your gain when your business or investment property is exchanged for “like-kind” property.
By using the “like-kind” exchange rules under Section 1031 of the Internal Revenue Code, you can sell your rental or other business or investment property, pay no immediate taxes and use the entire net proceeds from the sale of your old real estate to purchase other business or investment real estate.
So long as the purchase price of your new replacement property is at least as much as the selling price of your sold real estate, you can defer the taxes indefinitely. If your replacement property costs less than the selling price of your sold property, you have certain mortgages discharged or you receive non-“like kind” property, like cash, you may have to recognize some gain on the sale.
Who qualifies for a “like-kind” exchange?
Any taxpayer can qualify for a tax deferred “like-kind” exchange. It does not matter if you are an individual, partnership, limited liability company, corporation, estate or trust, you can still qualify for the tax deferral.
What is “like-kind” property?
If you exchange a residential rental apartment building for a residential rental apartment building, that clearly meets definition of “like-kind” property. However, “like-kind” property is not limited to identical property. As long as your replacement property is used for business or investment, it generally qualifies for “like-kind” treatment. You can replace your office building with an apartment building, your vacant land held for investment for a retail store or your industrial building for a shopping center.
Prior to the passage of the 2017 Tax Cuts and Jobs Act signed by President Trump last December, certain personal property also qualified for “like-kind” tax deferral treatment. However, now it is only available for real estate. And you do not have to own 100% of the replacement property. You can purchase a fractional interest in a larger business or investment property as tenants-in-common with other investor partners and still qualify for the like-kind tax deferral.
How do I structure a “like-kind” exchange?
You could just swap your rental or other business or investment property directly with the person who has the replacement property. However, you do not have to. You can have a delayed exchange by using a qualified intermediary, who would hold the proceeds of the sale of your old real estate. The qualified intermediary would then use those funds to purchase replacement property, so that you, in fact, would have exchanged the rental or other business or investment property for the replacement property. You just have to identify the replacement property within 45 days of the sale of your sold property and close on the purchase of your replacement property within 180 days of the sale of your sold property.
You can also do a reverse exchange in which your replacement property is purchased before you sell your old rental or other business or investment property. The replacement property is purchased by a qualified intermediary with whom you can park the replacement property for no more than 180 days, during which time you must sell your old property.
Can I act as my own facilitator for a deferred or reverse exchange?
Generally, no. If you take control of cash or other proceeds before the completion of the exchange, it could disqualify the entire transaction from “like-kind” exchange treatment. In such instances, all gains would be immediately taxable. You must use a qualified intermediary. Your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in any of those capacities within the previous two years is not eligible to act as your qualified intermediary.
Be careful in your selection of a qualified intermediary. There have been reports of unscrupulous individuals acting as intermediaries who declared bankruptcy or otherwise did not meet their contractual obligations to the selling taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. Then all the gain would be taxable immediately.
Can I use “like-kind” exchange treatment for the sale of my vacation or other second home?
Typically, a vacation or second home is considered personal use property rather than business or investment real estate. As such, it is not considered “like-kind” as either the relinquished or the replacement property. If you convert the property to rental for a period of time before the sale, you may be able to consider it for use in a “like-kind” exchange. Be wary of promoters with sales pitches to use them to get “tax-free” exchanges of your vacation or second home. They are usually only looking for a fee and are not particularly interested in your tax bill.
If you are considering a tax deferred “like-kind” exchange, seek advice from a competent tax professional before you sell your old property and/or purchase your replacement property. Also thoroughly investigate any qualified intermediary before you give them any money.
By Matthew M. Wallace, CPA, JD
Published edited July 22, 2018 in The Times Herald newspaper Port Huron, Michigan as: Sell your real estate; pay taxes later