People frequently don't think about the tax ramifications when selling a property until it is too late. Once you sell a property, you may have a tax obligation to pay, but in some cases you can defer payment to another time. Some people might choose to pay to be free of the obligation. However, paying may not be in your best interest if you can use the payment money to generate more money. If you defer long enough, you may be in a lower tax bracket and pay fewer taxes by the time you retire.
For an investment property, capital gain taxes are due upon the sale. These taxes can be sizeable because they include:
• Tax on depreciation (25 percent);
• Federal taxes (15-20 percent);
• Tax on net investment (3.8 percent);
• State tax, if applicable.
So if you want more control of when you pay taxes, consider a 1031 Tax Deferred Exchange. Here are the general rules -- not all the rules, but at least you will get the idea of how, and if, a TDE may benefit you.
First, understand the type of properties that qualify. The property must be held for trade, business or investment. Exceptions to this rule do not qualify and include: stocks, bonds, notes, interests in partnerships, property held for development, primary residence or second homes (and more). A mistake here becomes an immediately taxable event.
Second, the properties must be like-kind. The only definition for like-kind is "property for trade, business or investment," but you should be safe with any combination of real estate (including improvements if applicable) within the United States. For example, vacant land in Alaska could be exchanged for a rental property in Anchorage and a duplex in Arizona.
Third, you cannot take control of any cash or proceeds before the exchange is completed. You will need a Qualified Intermediary to hold your proceeds. The cost for a QI services vary, but should be around $300-$700 depending on whether the transaction is a simple sale or a purchase.
Since you are entrusting your proceeds with a company, be sure to do the necessary due diligence. If the QI fails to perform, you will have a taxable event, so know how your proceeds are protected. Is the QI backed by a larger credit-worthy company? What kind of account will your funds be held in? Does the QI have sufficient fidelity bond coverage?
Fourth, the timeframes are set in stone -- no extension or exceptions. You have 45 days, after the date of sale of the original property, to specifically identify the potential replacement properties in writing to your QI. You are limited in what you can identify: a) up to three properties of any fair market value, or b) any number up to 200 percent of the original property value. If you identify in excess of the above, you must acquire 95 percent of the value of all properties.
You have 180 days to record on the replacement property or the date you file your tax return (including any extension) for the year of the sale -- whichever is earlier. To take maximum benefit of the TDE you must reinvest all of the net exchange proceeds and acquire properties with the same or greater debt.
Finally, you can combine a TDE with the sale of your principal residence. For example, if you rented out your principal residence for two years, then sell it, taxes are paid in a prorated share between principal residence and TDE. The same would be true if you owned and lived in one unit of a multi-family building or used part of your home for business purposes.
Think of a TDE as one transaction with multiple parts. It takes a little planning, but you can delay paying taxes while slowly growing your real estate portfolio.