Clogged toilets. Calls at midnight, water leaks, late rent. The list goes on and on if you are a landlord.
I once owned a property back in the late 80’s (Yes, I was young at the time) that was supposed to be delivered empty. I walked through the units the day of the closing, and all looked good.
After the closing….that was a different story. It turned out the previous tenants moved right back in…along with all of their belongings!
When I called the police, the tenant produced a gas and electrical bill with their name and address on it and the officer said, “It looks like they live here to me”.
Needless to say, I was young, and they were pros. They had done this before and knew the system well.
Okay, so let’s say you own a piece of rental property (by the way, this could be residential or commercial) and you are tired of being a landlord and dealing with the hassles.
Well, one option that most choose is to simply sell the property.
However, let’s say you own a piece of property that you bought 30 years ago for 100k and it is now worth $1,000,000.
If you sold it, you would be subject to capital gains taxes. Here’s how it could look:
- Purchase price $100,000
- Improvement costs over the years, $250,000
- Sales price $1,000,000
We can subtract out the realtor costs of $50,000
For a simple example it looks like this:
$1,000,000 - $100,000 - $250,000 - $50,000 = $600,000 capital gain
There is also depreciation recapture that could increase your tax liability but let’s keep it simple for this illustration.
The capital gains tax rate on the $600k would be 20% or $120,000.
If paying that tax doesn’t sit well and you don’t need the cash but would like to continue receiving income, there is a solution.
A 1031 exchange, also known as a like-kind exchange, is a tax-deferred transaction allowed under Section 1031 of the Internal Revenue Code in the United States. This provision allows individuals or businesses to sell certain types of property and reinvest the proceeds into another property of a like kind, while deferring the capital gains tax that would typically be due upon the sale.
Here's how a 1031 exchange works:
Both the property you're selling (the relinquished property) and the property you plan to purchase (the replacement property) must be held for productive use in a trade or business or for investment purposes. Personal residences do not qualify for a 1031 exchange.
To facilitate the exchange, you must work with a qualified intermediary (QI) or accommodator. The QI helps ensure that the exchange complies with IRS regulations and that you don't take possession of the sale proceeds during the exchange process.
There are strict timing rules in a 1031 exchange:
Identification Period: Within 45 days of selling the relinquished property, you must identify potential replacement properties in writing to the QI.
Exchange Period: You must close on the replacement property or properties within 180 days of selling the relinquished property or by the due date of your tax return, whichever comes first.
The replacement property must be of a like-kind to the relinquished property. In this context, "like-kind" is broadly defined and can include various types of real estate, such as exchanging residential for commercial property or vacant land for rental property.
The entire net proceeds from the sale of the relinquished property must be reinvested into the replacement property to defer all capital gains taxes. If you receive any cash or other property not of like kind, it will be subject to capital gains tax.
No Personal Use:
After the exchange, you must continue to hold the replacement property for productive use in a trade or business or for investment. Using it as a personal residence would disqualify the exchange.
Capital Gains Tax Deferral:
The primary benefit of a 1031 exchange is the deferral of capital gains taxes. When you eventually sell the replacement property, you will have to pay capital gains tax on the gain at that time. However, by using 1031 exchanges strategically, you can potentially defer taxes indefinitely.
When you pass away, your 1031 exchange property gets a “Step up in Basis” which means if your family sells it upon your death, they will potentially pay no (or little) capital gains taxes.
But wait, Rick. If I do this 1031 exchange, aren’t I just trading one headache property for another with potential worse tenants?
That is where a 1031 DST (Delaware Statutory Trust) can come in.
It allows you to take an ownership interest in a much larger piece of property and own a fractional share of this property.
Let’s say a building has 1000 apartment units in it and you exchange your 3 unit building into it. You now own a share of that new building and receive income on your share of ownership.
This blog was meant to simply touch on this concept but there are lots or pieces to this process.
It's essential to consult with tax professionals and legal advisors experienced in 1031 exchanges to ensure compliance with IRS rules and regulations, as they can be complex. The process must be meticulously followed to qualify for the tax deferral benefits provided by a 1031 exchange.
Want to learn more about 1031 exchanges or chat about anything else?
Schedule a complimentary call with me. Click on my calendar link HERE
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In good health.
All the best.
In good health.
Rick Fingerman, CFP®, CDFA®, CCPS®
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, health, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.