Q I would like to know if it’s possible to sell my rental property (out of town, 20 acres with a house) and divide the profit and reinvest in two rental houses near my home in Lynnwood without paying capital gains. – G.D., Lynnwood
A Yes, you can use a tax-deferred exchange to accomplish the rollover, but you have to be very, very careful.
Section 1031 of the Internal Revenue Code allows you to roll the profits from property held for investment or used in a trade or business into like kind replacement property. Like kind simply means that the replacement property must also be held for investment or used in a trade or business.
Contrary to popular belief, you don’t have to go from one rental house into another rental house, or from a commercial building into another commercial building. You can exchange raw land for a rental house, a rental house for an apartment building, an apartment building for several rental houses, etc.
You just have to be sure you are trading one investment property for another investment property or properties. You cannot roll the proceeds from the sale of a rental house into the purchase of a personal residence, because your home is not an investment property.
However, setting up a tax-deferred exchange involving multiple properties is easier said than done. The IRS gives you only 45 days to locate a replacement investment property and 180 days to close on the purchase of that property. That’s a very tight deadline. It’s even tougher when you have to find two replacement properties within that time limit. But it can be done if you plan in advance.
Start looking for replacement properties now. Don’t wait until you sell your existing property. That gives you more time to make an intelligent decision. The 45-day clock starts ticking the day you close the sale of your current property. Many real estate agents tell stories about frantic investors desperately scrambling to find an acceptable rental property to buy as their 45-day time deadline ticks down to the last few days.
Sometimes these investors end up with a less-than-ideal property that they would never have purchased under normal circumstances. Don’t put yourself in that position.
Once you get a purchase offer on the property you are selling, try to delay the closing for as long as possible. The buyer may be able to close the deal within 30 days, but if you extend the closing date 60 or 90 days out, you add a month or two to your exchange deadline.
To qualify for a tax-deferred exchange, the purchase price of the replacement property must be equal to or greater than the sales price of your current investment property.
For example, if you sold your 20 acres and house for $300,000, you could purchase two rental houses that cost $150,000 each. The $300,000 combined value of the rental houses would equal the sales price of the property you are selling.
This can be done in any combination, such as a $100,000 rental condo and a $200,000 rental house, as long as the combined purchase price of the two investment properties equals or exceeds the value of the property you are selling. Your new combined mortgage balances must also equal or exceed the mortgage balance on your old property.
To complete a tax-deferred exchange, you must use an intermediary known as an exchange facilitator. You cannot have any direct contact with the cash proceeds from the sale of your investment property during the exchange period or it becomes taxable income.
An exchange facilitator is similar to an escrow company in that it holds the money from the sale of your investment property. But unlike an escrow company, the exchange facilitator actually participates in the transaction as a buyer and seller rather than a neutral third party. You have to be certain that you’re dealing with a reputable firm that won’t run off with your money before the exchange is complete.
A Section 1031 exchange is an excellent way to keep the value of your real estate portfolio growing without giving up a chunk of your profits in capital gains tax every time you sell. Just be sure to follow the exchange rules to the letter. The IRS is very strict and there are no extensions allowed if you miss a deadline.
Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435, or e-mail him at economy@heraldnet.com
Steve Tytler is a licensed real estate broker and owner of Best Mortgage, Inc. You can visit the Best Mortage Web site at www.bestmortgage.com.
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