Use 1031 exchange to defer rental property sale taxes
Q: My wife and I are about to sell a Chicago rental property we purchased together. The house was our first home, and we moved out about seven years ago.
After we moved out, we rented out the property. We transferred the property to our Schedule E on our personal joint income tax return, and when we sell, we should receive around $100,000 in proceeds. We would like to have the proceeds deposited in a company account and use them to buy and rehab properties, but we don’t want to do a 1031 exchange.
How can we avoid paying taxes on these proceeds? Would that be a function of our adjusted cost basis on the property?
A: You’ve got quite a bit packed into a short question. From what you’ve told us, we have no way of knowing if you have made a profit on the sale, and that’s key to figuring out how to move forward.
In simple terms, you must figure out your cost basis: what you spent to buy the house, what you spent on things the IRS would consider to be part of the house and the costs of selling it. Subtract these figures from sale price to figure out if you have made or lost money.
In much of the country, real estate values have grown since the Great Recession. However, property values in Chicago haven’t done much; some properties are worth what they were 20 years ago.
If you’ve lost money on the sale, you may have no income taxes to pay even though you end up with cash at closing. On the other hand, if you figure out that you have a profit, you’ll have a complicated time figuring out what your tax situation is. As a rental property owner, you probably took depreciation on the home and received a benefit on your federal income taxes. If you have to repay that depreciation, you’ll pay a tax of around 25% on the recaptured amount.
Here’s how it works: Let’s say you took $40,000 in depreciation over the time you owned the home. In this situation, you might owe $10,000 in depreciation recapture. And if you have a profit of $50,000 on the sale of the home, you’ll likely pay up to 20% in capital gains taxes on that profit or about $10,000 plus some other lesser taxes.
Note: We’ve oversimplified the possible tax situation you might face, but in this scenario you’d owe around $20,000 in federal taxes plus perhaps a couple thousand dollars in state taxes. The only way we know of that you can efficiently and effectively defer paying taxes on the sale of the property is by using a 1031 exchange.
In the simplest terms, a 1031 exchange allows you to sell your property, deposit all proceeds of the sale with a 1031 exchange company (aka a 1031 exchange intermediary), then find a replacement property within 45 days of the sale, and then close on that property no later than 180 days after the date of the closing of the rental property you currently own.
While you might find some permutation of the 1031 exchange that allows you to sell your home and then find a replacement property, do some rehab on that property and later own that same property, we wonder if such an option would be too costly given the amount of profit you’re expecting on the sale of the home.
Ilyce Glink is the CEO of Best Money Moves and Samuel J. Tamkin is a real estate attorney. Contact them through the website ThinkGlink.com.