Do I Have To Pay Taxes When I Sell My Rental Property?
This Question was Originally Submitted to THE MIDCOAST MONEY MEMO, hosted by Eric Simonds CFP®. The Midcoast Money Memo Runs Each Saturday on Radio 9 WCME. Listen LIVE Here 24-hours a day
Q: (Kittery, Maine) I bought a rental property years ago (17 years to be exact). I originally paid $112,000 for it. I keep pretty good records and can prove $50,000 in documented improvements on the property. I listed it earlier this year and now have it sold and under contract for $235,000.00. My accountant suggested a 1031 exchange but since she is on her annual post tax season trip, I am unable to get any answers from her. First, what is a 1031 exchange and what do I need to know.
A: Congratulations on the sale! If I may digress briefly, this spring (going into summer 2015) looks very promising in terms of real estate as the The Maine Real Estate & Development Association Index (or MEREDA Index) is up a record 25% to 110, returning our housing market to pre-2008 numbers. The MEREDA Index is a key measure of the Maine real estate market’s health, and just happened to be developed by Charles Colgan, one of my favorite professors from my time at USM’s Muskie School.
Back to our question, the good news about a 1031 exchange is that it could defer the taxable gain on the sale of your property. In the scenario you described, we are talking about a possible tax bill of over $20,000.00 (this includes depreciation recapture) that you may not be paying this year. I would like to call your attention to the most important word in the above sentence: defer. You will still owe the tax and are in effect just delaying the inevitable (you know what they say about “death and taxes”). If you are selling the property because you want/need your proceeds, this may not be the right answer for you.
A 1031 exchange is fair amount of work and should only be facilitated by a competent certified professional. As your accountant (who is conveniently on vacation, leaving the heavy lifting for yours truly) may have shared with you, the main drawback (outside of the complexity) is that the proceeds from the initial sale need to be used for a like-kind property. To put that in english, that means that to avoid some or all of the taxes you would only be able to purchase a piece of property sharing the same characteristics, in this case, another rental property. For some this is a tall order, especially in a tight market like we are currently experiencing. Tall order or not, in my opinion, saving $20k in taxes would justify you pursuing this further to figure out if it makes sense for you.
One important thing to remember is that the tax savings is not automatic. The amount able to be deferred (which can vary wildly) is dependent on several factors, some of which are in your control, such as the price of property you select as a replacement and many outside your purview (i.e. is the seller willing to operate within the necessary times frames? Does a suitable replacement exist in the current inventory? Are you able to obtain financing? etc.). Knowing nothing about your personal financial situation, the biggest problem that I can see is finding a substitute property in the present low-inventory market. Also I am left wondering if you even want another rental property, as I am guessing that if you have sold this one, you may be tired of being a landlord.
There are many variables that prevent me from definitively advising you one way or the other but I will continue to provide you information for you consideration.
The formula can be complex and daunting. When I sat for the Certified Financial Planner™ exam I had to memorize all nine (9!) steps and do it long hand.
Here is the formula
PLACEMENT PROPERTY BASIS FORMULA
Relinquished Property Adjusted Basis ____________
Plus: Any other Property Transferred +____________
Plus: Liabilities Assumed by Taxpayer +____________
Plus: Amount of Cash Paid by Taxpayer +____________
Plus: Gain Recognized on other Property +____________
Less: Money or Property Received -____________
Less: Liabilities assumed by other Party -____________
Less: Loss Recognized on other Property -____________
Equals: Basis in Replacement Property ===========
Thus if you sell the property and do not choose to do the exchange you will be paying capital gains tax on the proceeds of $235,000 less the basis of $162,000, for a total taxable gain of $73,000 and then there is depreciation recapture to consider.
In addition to add to the complexity and cost, you will need to employee a qualified intermediary to execute a 1031 exchange and all funds are essentially held until the new like-kind property is purchased or the time lines elapse and you must receive the proceeds and associated liability.
The time requirements for purchasing the new property are essential to follow as you have 45 days to identify a property and 180 days to complete the new purchase.
You can do a partial exchange in which you defer some of the gain by purchasing a “lessor” like-kind property and paying taxes on the remaining portion as determined in the formula above.
Please be advised if you choose to go this route, the exchange is reported on Form 8824, which I am sure your accountant will handle.
Finally, your current options are limited and narrowing as you get closer to closing day. If you had contacted me earlier we could have discussed putting the property into a charitable trust prior to the sale, and thus the trust would be the seller, but it appears too be late now, unless this sale falls through. Although that last part may not be of any help to you, someone reading this may have just learned of another option for their situation.
Good luck and please let me know how it turns out.