Review of all things Real Estate: Avoid capital gains tax on your investment property sale

Some might ask; Bob, is this article timely? 1031 Exchanges are not snap decisions, they require deliberate thoughtful action. Plus, the mortgage interest rates will come down so future purchases won’t feel so daunting; good planning will save capital gains taxes. My articles are about education and awareness, not about selling.

By Alicia Tuovila and other internet sources

With appreciated stock, you can sell your shares over a number of years to spread out the capital gains. Unfortunately, investment real estate is not granted the same luxury. The entire gain amount must be claimed on your taxes in the year the property is sold, unless certain steps are taken to minimize this risk.

If an investor uses IRS Code Section 1031 (1031 Exchange) to recognize a "like-kind" exchange when selling an investment property, capital gains can be deferred by purchasing a similar investment property.

You can mitigate this tax burden by controlling the year in which title and possession passes out of your hands and the year in which you report the capital gain on the transaction. In other words, you can set the transfer of ownership to a year in which you expect to have a lower tax burden.

A 1031 Exchange allows an investor to trade real estate held for investment for other investment real estate and incur no immediate tax liability. Under Section 1031, if you exchange business or investment property solely for a business or investment property of a like-kind, no gain or loss is recognized until the newly acquired property is sold.

Beginning in 2018, The Tax Cuts and Jobs Act limited like-kind exchanges to real estate. Section 1031 exchanges of personal property, such as artwork, are no longer permitted.

A 1031 Exchange will not allow the avoidance of capital gains taxes in all cases. For example, the exchange of U.S. real estate for real estate in another country will not qualify for tax deferred exchange status.

Furthermore, trades involving property used for personal purposes, such as exchanging a personal residence for a rental property, will not receive tax deferred treatment. If an exchange is made between related parties and either party subsequently disposes of the exchanged property within a two-year period, the exchanged property will become subject to tax.

For tax reporting purposes, the basis of the old property is carried over to the new property. This is important to understand because the taxes due are not forgiven, they are simply postponed until the sale of the new property. To record the 1031 Exchange with the Internal Revenue Service, it is important to file Form 8824 with the tax return for the year of the like kind exchange, as well as for each of the two years following the exchange. 

A tax-deferred exchange is also possible if you are selling your investment property at a loss. First, you must determine if the loss is a "tax loss" or just a personal loss. In order to qualify as a tax loss, your adjusted basis in the property must be more than the selling price of the property. Your adjusted basis takes into consideration any prior depreciation deductions you have taken.

For a tax deferred 1031 Exchange transaction to occur, certain conditions must be met:

• The property must be "like-kind": Properties are like-kind if they are of the same nature or character, even if they differ in grade or quality.

• The property must be related to business or investment: Exchanged property must be held for productive business or investment use and traded for the same use. An exchanged property must not be primarily held for resale.

• The new property must be identified within 45 days: The new property to be received in exchange for an existing property must be identified in writing, to the seller, within 45 days of the first transfer.

• The transfer must take place within the 180-day window: The like-kind property must be received by one of these two dates (whichever comes sooner); within the 180-day period following the property transfer, or by the tax return due date (including extensions) for the year in which the property is transferred.

The increased number of real estate sales has allowed many people to receive favorable tax treatment from the federal government. As a result, a tremendous amount of tax revenue has been lost so this program is frequently the subject of review but for now, 1031 Exchanges for real property remain. (as mentioned above, beginning in 2018, they were eliminated for other types of property, such as collectibles, aircraft, franchise rights, and heavy equipment.)

As always, discuss your plans with a tax professional if you have a rental property you are considering selling to learn which rules apply to your situation.