Ins and outs of selling a rental

Published 2:55 pm Friday, December 3, 2010

Question: We know that the tax laws allow homeowners to sell their house and keep the profits tax-free, but what about rental properties? We own a rental house and we want to know if we can sell it and keep some or all of the profits tax-free?

Answer: 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 what’s called a 1031 Exchange.

Internal Revenue Code Section 1031 allows real estate investors to sell an investment property and buy a replacement of equal or greater value without paying tax on the profit from the sale. The capital gains tax liability is not eliminated, it is merely deferred until the last investment property is sold for cash. That’s why a 1031 is commonly called a tax-deferred exchange.

The 1031 rules are strict and they must be followed to the letter or the exchange is invalidated. To qualify, 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 to identify replacements in the exchange, and the purchase transaction must close within 180 days of the closing date on the old 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. Investors sometimes use an unusually long escrow period of three to six months in order to give themselves more time for the replacement. Or, if they are still trying to sell their existing property, they might tie up the replacement with a lease-option contract, then exercise the purchase option after the old property has sold.

In a tax-deferred exchange, the replacement property must meet strict eligibility requirements. Not only must it 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 taxable.

In fact, if the exchanger has what’s called constructive receipt of the proceeds at any time during the exchange, it’s taxable. Constructive receipt simply means the money is available. 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 it.

To avoid that pitfall, investors typically hire a professional exchange facilitator. Contrary to popular belief, you do not have to literally exchange one property for another one to qualify for a 1031 exchange. In most cases, you simply sell your existing property in the normal manner, but never touch the money. The money is held by the facilitator who acts as the seller. Once you have a contract to buy the replacement, the facilitator acts as the buyer. It sounds very complicated, but it is really just more paperwork.

Through a process called direct deeding, the deed to the property being bought or sold by the facilitator is automatically transferred to the appropriate buyer or seller at closing.

Since the facilitator will be holding all of your money during the exchange period, you must be sure that he or she doesn’t skip town. Make sure the exchange facilitator you deal with has a fidelity bond or some other way to guarantee that your funds won’t disappear.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206, or e-mail him at economy@heraldnet.com.