Let me explain what it is as simply as I can. Pretend you purchased an income property in 2000 for $100,000. Even in today’s market, it’s now worth $175,000, and you have a full price offer. After the expenses of selling it and the cost of improving it over the last eight years, you are set to realize a profit of $50,000. If you choose to pocket this money at closing, you will pay capital gains taxes on it.
But wait, there’s more. Remember all of that wonderful depreciation that helped so much on your taxes? If you’re going to cash out, the government would like it back (called depreciation recapture). Unless…instead of pocketing the money, you choose to reinvest. This can help you avoid not only the capital gains tax, but the depreciation recapture as well.
A 1031 Exchange allows you, at closing, to assign the proceeds of the sale to someone called a qualified intermediary. For a small fee, this company or entity holds the money until you pick out a replacement property. When you close on that property, you tell the intermediary to send your $50,000 to the closing as your down payment.
Now, there are restrictions. The biggest is time. You must identify up to three replacement properties within 45 days of closing on the sale of your property. From the date of that closing, you have 180 days in which to buy one of those. If you fail to close, the money is yours to pocket. You’ll just have to pay the taxes and depreciation recapture.
It is essential that when you sell your original property that your Realtor specify in the purchase agreement that the buyer agrees to cooperate with you in a 1031 Exchange. Usually, this doesn’t effect the buyer whatsoever, but the IRS requires you to state it.
There are also some restrictions on the kind of property you buy. If you have a four unit building, you are not required to purchase another four unit building in order to qualify for “like kind”. It can be a duplex for a fourplex, an apartment building for a mobile home park; essentially, real estate for real estate. The price of your purchase, however, must be equal to or greater than the one you sold to shield the entire gain. Of course, you can always choose to exchange part, pocket the rest and pay taxes on it. And for the record, any piece of it you personally touch is called “boot”.
By doing this exercise each time you sell and buy property, you can defer paying capital gains and depreciation recapture infinitely. Be forewarned; should you choose to sell to fund your retirement, you will have to pay the tax and recapture all the way back to the date of your original investment. However, if you left your properties to your kids, and they chose to sell, they would only be required to pay inheritance tax.
There are some other strategies for selling income property as you head toward retirement, but for the most current and accurate information, be sure to talk with a qualified CPA. (And, be advised, they aren’t all familiar with this process. Find one who is!)