With 1031 exchange, you can beat big home-sale tax bills - Military Financial Advice - Army Times

With 1031 exchange, you can beat big home-sale tax bills

Purchasing a home before retirement and renting it until you retire can be an excellent strategy.

But selling rental real estate, especially when you have owned the property for a long time, can create a large tax bill that can substantially reduce the amount of cash you receive from the sale.

There is a way to sell your property, transfer the proceeds to a new rental property and pay no tax on the sale; this strategy makes use of a 1031 exchange. This exchange, named after the corresponding IRS code section, is also commonly called a "Starker exchange" or a "like-kind exchange."

To do a 1031 exchange, you must purchase a new rental property soon after the old rental property is sold. The rules are complex, so you should seek professional help — an attorney and an accountant — to assist you in making the exchange.

When using a 1031 exchange, keep in mind a few rules:

• Proceeds from the sale of your rental property must be used to purchase the new property. If you take out any cash, that money is taxable in the year you sell the old property.

• Mortgages create complications, so be sure to consult your tax adviser. You should never assume a mortgage on the new property or allow anyone to assume the mortgage on the old property.

• The best way to effect the exchange is to use an attorney who is a qualified intermediary for 1031 exchanges. The lawyer will hold the sale proceeds in escrow until the new property is purchased.

• You must identify a replacement property in writing within 45 days of the date of sale of your property. You may identify up to three properties; if a written identification is not made within the 45-day period, the proceeds are taxable and no 1031 exchange occurs.

• The replacement property or properties must be purchased within 180 days of the sale of your property.

• When you file your tax return, you will have to fill out IRS Form 8824 (Like Kind Exchanges). Get professional help — do not expect tax software to do it for you.

If the new property later becomes your primary residence, you own the property for at least five years and you live in the property for at least two years, you can avoid paying taxes on most of the gain when the home is later sold. Keep in mind, though, that depreciation deductions taken previously on the rental property are taxed when your residence is sold if the depreciation was taken as a deduction after May 6, 1997. Consult your tax adviser for details.

If you have a loss on the property to be sold or if the gain to be deferred is small, a 1031 exchange may not be the right strategy. If you carry forward significant tax losses from investments previously sold at loss, all or part of your rental real estate gains may not be taxed. Watch out for the alternative minimum tax in this scenario.

Keep in mind that you cannot create a 1031 exchange after the sale; it must be set up before you sell the property.

The taxes incurred on the sale of rental real estate can be substantial. If the property has a large mortgage and has been a rental property for a long time, then it is possible that the taxes due may exceed the cash proceeds. A 1031 exchange can reduce or eliminate your taxes on the sale of rental real estate and give you significantly more money to reinvest in other real estate properties.

One final note: If you are a service member who owns a home that you later rent to others when you are sent to another duty station, a new regulation allows you to claim the home as your principal residence under certain conditions. You can choose to suspend the residency requirement for up to 10 years. If, in the past 15 years, the house was your principal residence for at least two years, the sale will be treated as the sale of your principal residence and not as the sale of a rental property. However, even if the home is sold as your principal residence, you must pay taxes on the total depreciation deductions taken after May 6, 1997.

Barbara Pietrowski is a licensed certified public accountant, certified financial planner and personal financial specialist. Her practice includes tax preparation, fee-only financial planning and investment management. E-mail her at barbarapietrowski@yahoo.com.