If you bought rental real estate years ago before the Great Recession and it has gone down in value, you might have a big gain if you sell it. That is especially true if it is rental real estate and you have claimed depreciation expense for many years.
The way to postpone the gain might be to trade it for other investment real estate of equal or greater value. Section 1031 of the Internal Revenue Code allows you to trade for “like kind” property without paying tax on the gain unless you get cash out and/or have more mortgage given up than mortgage assumed on the new property.
Sure, the rules are tricky, but the tax free trades are done all the time.
If you bought property for $100,000 say 10 years ago and you have claimed about $30,000 of depreciation expense (after allocating something to land), then your tax basis is about $70,000. If it is worth $90,000 today and you sold it, the taxable gain would be $ 20,000. Your prior year taxes were reduced because of the depreciation expense. You can avoid being taxable on that gain if you do a section 1031 exchange.
To meet the section 1031 deadlines of 1) you must identify possible replacement property within 45 days of sale of the old property and 2) you must receive title to the new property within 180 days of the sale date for your trade will qualify.
If you sell the property late in the year and replace it in the following year, be sure to not file your tax return until the transaction is fully completed. You might get an extension of time to file just to be sure.
However, some folks have been surprised to learn that if they had $50,000 of mortgage on the old property and the new property only has $30,000 of mortgage, the reduction of $20,000 is taxable “boot.” If you receive property with a greater mortgage than what you gave up, you don’t have taxable “boot.”
Congress defines “like kind” real estate in an interesting manner. A sale of an apartment house with a purchase of bare land qualifies. An exchange of real property located in the United States for real property located outside of the United States does not qualify. Most exchanges of real property qualify.
You can trade raw land for a commercial building or vice versa. However your home does not qualify as investment real estate in the eyes of the tax code.
There is a special rule about dealing with related parties. If you receive property in a like kind exchange with your controlled partnership or related persons, and they sell the property before two years has passed, the original exchange does not qualify for tax free trade status.
If you hold your new property until death, the “step up in tax basis” will be a benefit, you just have to die to get it for your heirs. The gain is not taxed at all.
Did you hear? “Whatever your lot, cultivate it.”
John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Co. CPAs.