A: Current tax law allows homeowners to keep up to $250,000 in capital gains ($500,000 for a married couple) tax-free when they sell their home, but there is no such tax break for rental property owners.
The only way to avoid paying capital gains tax on the sale of your rental house is to use a "1031 Exchange." Internal Revenue Code Section 1031 allows real estate investors to sell an investment property and buy a replacement investment property (or properties) of equal or greater value without paying tax on the profit from the sale of the "old" property. The capital gains tax liability is not eliminated; it is merely deferred until the investor ultimately sells the last investment property for cash. That's why a "1031 exchange" is commonly called a "tax-deferred exchange."
The 1031 exchange rules are very strict, and they must be followed to the letter or the exchange is invalidated and all profits from the property sale become fully taxable. To qualify for a tax-deferred exchange, you must trade "like kind" properties, which means both the "old" and "new" properties must be held for investment or use in a trade or business. The properties can be raw land, single-family homes, apartment buildings, commercial buildings, etc.
Investors have only 45 days in which to identify the replacement property (or properties) in a 1031 exchange, and the purchase transaction must close within 180 days of the closing date on the "old" investment property. That's a very tight deadline, which is why investors usually try to find a property they want to buy before closing the sale on their existing property. Since the 45-day clock doesn't start ticking until the sale of the "old" property has closed, investors sometimes use an unusually long escrow period of three to six months in order to give themselves more time to locate and negotiate the purchase of a replacement property. Or, if they are still trying to sell their existing property, they might tie up the replacement property with a lease-option contract, then exercise the purchase option after the "old" property has sold and complete the transaction as a 1031 exchange.
In a tax-deferred exchange, the replacement property must meet strict eligibility requirements. Not only must the replacement property be of equal or greater value than the property being sold, but the mortgage on the new property must be of an equal or greater amount than the existing debt on the property being sold. Any excess cash that ends up in the exchanger's hands at the end of the deal is called "boot" and becomes taxable income.
In fact, if the exchanger has "constructive receipt" of the sale proceeds from the "old" property at any time during the course of the exchange, it immediately becomes taxable income and the exchange is invalidated. Constructive receipt simply means the money is available to you, whether you touch it or not. For example, if the money is placed in a savings account to which you have access, that would be considered constructive receipt even if you never withdrew any of the money.
To avoid the constructive receipt pitfall, investors typically hire a professional "exchange facilitator" to handle the exchange. Contrary to popular belief, you do not have to literally exchange one property for another one in order to qualify for a 1031 tax-deferred exchange. In most cases, you simply sell your existing property in the normal manner, but -- and this is the important point -- you never touch the money. The money is held by the exchange facilitator to whom you have assigned the right and obligation to act as the "seller" on your behalf. Once you have a contract to buy the replacement property, the facilitator acts as the "buyer" on your behalf and uses your money to purchase the property. It sounds very complicated, but it is really just a paper transaction. The exchange facilitator appears to be the "buyer" or "seller" (depending on which side they're representing) on all of the escrow papers -- except for the deed and excise tax documents. Through a process called "direct deeding," the deed to the property being bought or sold by the exchange facilitator is automatically transferred to the appropriate buyer or seller at closing. As far as the individual buyers and sellers are concerned, the only difference between an exchange and a normal sale is that there are a few extra documents to sign at closing.
When selecting an exchange facilitator, it is extremely important to know who you are dealing with. Remember, the facilitator will be holding all of your money during the exchange period and you cannot have access to it as explained above, so you must be sure that they won't skip town with your cash. Make sure the exchange facilitator you deal with has a fidelity bond, or some other way to guarantee that your funds won't disappear during the exchange process.
Steve Tytler is a licensed real estate broker and owner of Best Mortgage. You can email him at firstname.lastname@example.org.