Dodge a Real Estate Tax Trap
The real estate slump of recent years has reduced the value of many investment properties. Therefore, you may expect to owe little or no tax on a sale. You may, however, have to pay a surprising amount to the IRS because of a “recapture” provision in the tax code.
Repaying prior deductions
Owners of investment property generally reduce their taxes each year with depreciation deductions. Those deductions, however, also reduce your basis in the property and thus result in increased tax on a future sale.
Example: Paul Matthews bought a small apartment building many years ago for $500,000, of which $50,000 was allocated to nondepreciable land. The remaining $450,000 of the purchase price has been fully depreciated over the years.
Paul has seen the building’s value rise to $800,000 and then fall back towards $500,000 in recent years. He wishes to relinquish property management responsibilities and relocate to a distant state in retirement. He assumes that a sale that nets him $500,000 would result in no tax: paid $500,000, received $500,000.
However, Paul has taken $450,000 worth of depreciation deductions, as noted. Consequently, his basis in this property is only $50,000, not $500,000. If Paul sells the property for $500,000, his $450,000 of depreciation deductions would be recaptured at 25% and he would owe the IRS $112,500.
Trading places
In this scenario, Paul can execute a so-called “like- kind exchange” under Section 1031 of the tax code. If he meets all the requirements of Section 1031, some of which are outlined in the following section, taxes can be deferred. Such exchanges can involve any kind of investment property and they don’t have to be a straight one-for-one trade.
To give a simplified illustration of how a like-kind exchange might work, suppose Paul lives in New Jersey and wants to retire in North Carolina. He sells his New Jersey apartment building, and nets $500,000 from the sale, but he does not pocket the money. Instead, Paul arranges for the proceeds to be held by a qualified intermediary, sometimes known as an accommodator. (The accommodator can’t be Paul’s agent or relative. Many financial and real estate companies offer to serve as qualified intermediaries; if you are interested in a like-kind exchange, check prospective accommodators’ experience and safety procedures carefully.)
Next, Paul finds a storage facility near his desired retirement home that he can buy for $500,000. He instructs the accommodator to purchase the property with the $500,000 from the sale of his apartment building. As a result, Paul has “exchanged” his New Jersey investment property for one he’ll be able to manage once he retires in North Carolina.
Deferral defined
Like-kind exchanges can take many forms in addition to the one in the previous example. Regardless of the exchange’s form, you must follow many rules in order to defer the full amount of tax due on the sale of your original property. In a deferred like-kind exchange, certain deadlines regarding the identification and receipt of the replacement property must be met (see the Trusted Advice column “Deferred Like-Kind Details” for further explanation).
Assuming you follow all the rules, here are the requirements for a full tax deferral:
● You must pay at least as much for the new property as you received for the original property you relinquished.
● You must reinvest any cash you receive from the original sale into the new property.
● If you are relieved of any debt on your old property, you must replace that debt with a combination of new debt or cash, or both, that you add to complete the purchase of the new property.
If you implement an exchange and wind up with cash in your pocket or a smaller mortgage than you had before, the amount by which you benefit will be considered “boot” and subject to income tax. Like-kind exchanges are complex but they may result in substantial savings; if you’re interested, our office can help you meet all the requirements.
