A Way to Keep the IRS Away from Your Profits
Made some money in real estate? Use a 1031 exchange to roll over your gains. Just make sure you do it right.
(MONEY Magazine) – Here's a hot real estate tip: Forget about hopping a flight to Miami or Vegas; head to your accountant's office instead. The tax code offers some of the best real estate returns in the land--and its 1031 exchange provision is a tax break so fat it can make the mortgage deduction look like a cereal coupon.
A 1031 exchange works like this: You can put off taxes on your investment real estate gain if you roll your sale proceeds into a property of equal or greater value. You can't do this sort of rollover with your primary home. But you can unload that investment duplex you bought a few years back and trump Uncle Sam (or, more precisely, delay the pain by putting off tax day until you're in a lower bracket).
Anything involving the letters IRS can get tricky, of course. And 1031 exchanges come with many, many twists. Experts say smart exchangers do the following:
1 GET A GO-BETWEEN
You'll want to hire what the IRS calls a qualified intermediary (or QI) to exchange properties 1031-style. That's because you aren't allowed to touch the proceeds of your sale. If you do, you lose the tax advantage. (Think 401(k) rollover.) So when you sell your beach condo, the money goes to the QI, who holds it until it's time to deliver the funds directly to the closing agent for your new property. To find a qualified qualified intermediary, check out the Federation of Exchange Accommodators at 1031.org. (Yes, before QIs were called qualified intermediaries, they had the equally elegant name of exchange accommodators.) Make sure the QI is bonded and insured for negligence and fraud. The typical fee: $500 to $1,500 per deal.
You'll likely want other pros on your side. IRS rules state that you must identify your trade-up property within 45 days of the sale and typically close on it within another 135 days. You'd do well to tap a broker or lawyer who's handled 1031 exchanges and can turn around deals quickly. And while I'm a fan of do-it-yourself tax software, this wouldn't be the time I'd choose to slave over my PC with a Quicken CD; I'd hire an accountant.
2 COVER YOUR BASIS
As with most tax breaks, the devil is in the details. And the core moves that savvy real estate investors typically make (like depreciating property) can come back to haunt you. Example 1: You bought the property for $100,000. Over time, you depreciate it so that its basis for tax purposes is $50,000. You sell the place for $200,000. Think you're rolling $100,000 in gains into your next 1031 property? Think again: The IRS says it's $150,000 because of the 50 grand in depreciation. You'll want to remember a detail like that when it's time to finally settle with the IRS. Example 2: If you owe more on a property than the basis and your buyer assumes your loan (a common part of a transaction in investment real estate), the IRS sees a taxable gain for you in the liability you no longer owe to the bank. (Any depreciation only makes this gain larger, of course.) The lesson here: Avoid tapping the equity in your property like it's a piggy bank, or at least make sure you pay down the loan so it's well below your basis before exchange time.
3 DON'T GET GREEDY
The idea of sheltering gains is so attractive that some people jump into their next deal too quickly, says Stephen Hanleigh, a broker in San Jose who advises clients on exchanges. He should know. He once unloaded a California coastal property after local leaders nixed his development plans, trading into an industrial property not too far away. But the industrial project didn't appreciate as quickly as the place he'd sold. Moral: Sometimes, just pay the darn tax. "Too many people," he says, "wind up with bad properties because they rushed into a trade-up."