If you sell a rental property that has appreciated you
- pay taxes on your profits, or
- avoid taxes by qualifying for the primary residence exclusion, or
- defer taxes by buying another rental property.
The October 27 blog posting addressed the first two alternatives; now we will review the third option. The IRS refers to this transaction as a 1031 exchange.
When you sell a rental and use the money to buy another rental, the IRS recognizes that you don’t have any funds left over to pay taxes. Thus, they allow you to defer your tax payment. This includes deferring taxes on depreciation recapture (see October 27 posting). Thank you Uncle Sam!
Buying another rental cannot be an afterthought. To take advantage of the IRS tax benefits you must follow strict rules that begin before you sell your rental.
There are three basic requirements to qualify for the tax deferral.
1. You must hire a Qualified Intermediary to handle this transaction. You can’t sell your rental property, deposit the funds in your bank account, and then withdraw funds to buy your replacement rental. You will owe taxes on any funds that end up in your pockets.? The IRS wants a third party to handle the entire transaction.
2. You have 45 days from the time you sell your rental house to identify potential replacement properties. You have 180 days from the time you sell to buy the replacement property. The IRS is strict here.? If the 180th day falls on a Sunday and it is not possible to close until Monday, too late, your entire gain becomes taxable!
3. Lastly, the value of the replacement property must be more than the value of the relinquished property and the debt on the replacement property must be more than the debt on the relinquished property. ?If the value or debt is less, you can still defer taxes on a pro-rated portion of the gain, but not the entire gain.
As you can see deferring taxes only works if you plan to stay in the rental business. Perhaps your current rental is not in a convenient location or does not produce the revenues you need. If you can make the timing work, deferring your taxes through the 1031 exchange is a great strategy.