In 2020, I had a client sell a rental property for about $250,000 and sell their “forever home” for well over $1 million. They were shocked by how large the tax bill was for the rental property and how low it was for the primary residence. This has to do with certain tax breaks on the sale of a primary residence and the deferred nature of taxes on investment property.
Similar to your 401(k), the tax deferral looks great on paper as your balance sheet grows. Also similar to your 401(k), the tax bill will make you angry when you go to cash in your chips. However, in the rental business, there is an option to defer your taxes on the gain, so long as you meet certain requirements. At a very high level, 1031 exchanges allow you to exchange one investment property for a “like-kind” property and defer the taxes until you sell that next property.
The purpose of this column is not to examine the many nuances of this section of the tax code, but rather to help you figure out whether you may be a good candidate for a 1031 exchange. If it looks like you may be, you can get into the exciting details of the code. Below are four scenarios we see often.
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1. You’re facing a large tax bill.
Without a significant tax bill upon sale, there isn’t really any reason to consider an exchange. However, as noted in my first example, the tax bill is often higher than you expect it to be.
Because investment property is taxed at capital gains rates, folks often make the incorrect assumption that the calculation is the same as if you sold stock. With stock, if you bought XYZ at $100 and then sold it two years later at $150, you have a $50 capital gain. With real estate, it’s not that simple.
With a rental property, you depreciate the value of the actual home, typically over a period of 27½ years. In English, you essentially have a deduction against your rental income. It’s very helpful in reducing your taxes while you own the home, but that benefit gets “recaptured” at sale.
For example, you buy a property for $250,000 and depreciate it by $70,000 over the course of 10 years. Your basis in the property is now $250,000 minus $70,000 equals $180,000. The depreciation recapture typically taxes that $70,000 at 25%, right off the bat. Let’s say you sell the property at $300,000. It seems that the gain should be only $50,000, but it’s the difference between $180,000 and $300,000, or $120,000. You’ll pay about 25% on the first $70,000 and about 15% on the remaining $50,000. The reason I say “about” is because the rate depends on your income. Total tax bill in this scenario is $25,000.
We rely on software and experience to estimate these bills for clients. You can use the free version of our planning software here. However, given that these bills can be large, I would talk to your financial planner and/or tax adviser to get a sense of how much you may owe and what the overall impact on your plan would be.
2. You expect a lower future tax rate.
I write often about Roth conversions. The premise is that your current tax rate is lower than your future tax rate, so it makes sense to pay the bill today and skip it tomorrow. This scenario is the opposite and comes about if you’re in a higher capital gains bracket today than you will be in the future. This could be because you already had a large sale in the current calendar year, or your income pushed you above the 15% capital gains rate.
If this is the case, a 1031 exchange may defer the sale into a future year, when your tax rates have dropped. The most common scenario for Baby Boomers is that they have retired, which means that wages have dropped off their tax return (line 1) and hopefully lessened their tax burden.
3. You’re old enough to defer, defer, die.
The unfortunate reality is that Baby Boomers are moving closer to the third “d,” and therefore, this strategy is better suited to them than it is to Gen X or Millennials. Many will call this strategy a loophole. I’m not sure I’d go that far, but it is quite handy for those who have deferred gains for a long time.
This is where a sale of stock and a sale of investment property act the same. With both stocks and real estate, there is what’s called a “step-up” in basis at death. Let’s say you buy a property for $100,000 and die when it’s worth $500,000. Your beneficiaries don’t have to pay taxes on the $400,000 in gains that accrued during your lifetime. This applies even if you have exchanged several times before your demise, so long as you own the final property upon the aforementioned demise.
4. You don’t want to be a landlord.
For those ready to tap out of the landlord game, swapping one investment property for another seems like a strange move. Delaware statutory trusts (DSTs) are institutionally managed real estate properties or portfolios that qualify for 1031 treatment. Essentially, you become a fractional owner with management by professionals. They pay you a distribution, typically from the rent they receive. Sound too good to be true? It’s definitely too good to be free.
We have recommended these to clients, but I want to be very clear about the downsides. There are many layers of costs that can be uncovered in the investment offering’s legal documents. They, like most real estate, are also illiquid. Think of a plane ride. You’re on the plane from takeoff to landing. There are very few circumstances that would allow you to get out of the investment should you change your mind. Another way to think of this: You get to choose what and when to buy, but you no longer get to decide when to sell.
If all, some or any of these had you nodding your head, it’s time to get to know the 1031 exchange rules. I have had many a prospective client approach me to do this after they sold their property. Perhaps that’s the first thing you should know. If you’re going to do an exchange, you must know before you go to settlement on the current place. It’s kind of like money coming from a retirement account: If it hits your bank account, it’s taxable.
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