Investment Property Tax Information

If you are selling investment real estate that has a capital gain, you will be exposed to capital gains taxes. Gain is a combination of the following four variables:

1. Appreciation: How much more valuable is the property when you sell it compared to the value when you acquired it?

2. Capital Improvements: What capital improvements have you made to the property that have increased its value such as adding a room, installing a swimming pool, buying the fee, etc?

3. Depreciation: How much depreciation have you claimed on the property? The depreciation you have claimed is subject to recapture  at time of sale?

4. Rollover: Did you defer capital gains taxes from a prior sale by rolling the gain over into this property when you purchased it?

There are some rather complicated methods to avoid paying capital gains taxes on the sale of investment real estate through the establishment of special trusts such as a Charitable Remainder Trust or a Private Annuity trust. Such trusts have advantages as well as some decidedly disadvantages. In the 30 years that I have owned an Oahu real estate company to my knowledge, none of our clients has established such a trust solely to avoid paying capital gains taxes. For more information I recommend you search the Internet for general information and contact an estate attorney for specific assistance applicable to your situation.

Whereas none of our clients has established a special trust to avoid paying capital gains taxes, hundreds of our clients have used an Internal Revenue System (IRS) Section 1031 exchange to avoid paying capital gains taxes at time of sale. The Stott Team first introduced many of them to this concept. At any given time, we usually have several transactions in escrow where the seller will be conducting a 1031 exchange.

The remainder of this paper will be a very general overview as to what is involved in a 1031 exchange. Additional information can be found in this section of our website titled “1031 Exchanges.” It is an 8-page paper I wrote using a question and answer format that is designed for readers that have never been involved in such a transaction.

“There is nothing wrong with a strategy to avoid the payment of taxes. The Internal Revenue Service doesn’t prevent that . . .” William H. Rehnquist, Chief Justice of the U.S. Supreme Court (1986-2005)

NOTE: This is a very basic overview and is not intended to be a guide to a 1031 exchange, as it omits numerous rules and considerations that could impact upon an actual exchange.

NOTE: We are not licensed to provide either legal or tax advice. Licensed professionals such as attorneys and CPA’s should be consulted for such advice.

Section 1031 of the Internal Revenue Code (IRC) allows you to use the proceeds from the sale of real estate to buy replacement real estate without having to pay capital gains taxes. This paper will use the term disposable real estate for the property being sold and replacement real estate for the property being purchased. A common misconception is that you need to find an owner who wants to trade properties with you. Most 1031 exchanges involve two entirely separate transactions with the buyer of the disposable property having no contact with the seller of the replacement property. In fact, the disposable property and the replacement property are often in two different states.

Both the disposable property and the replacement property must be investment real estate; in most cases, they are rental properties. Almost any type of real estate qualifies such as a house, condo, store, office, or even vacant land. However, your personal residence does not qualify; i.e., neither your disposable property nor your replacement property can be your personal residence. But, you could rent replacement property first so that it qualifies as investment real estate and then subsequently occupy it yourself as your personal residence. The exchange does not need to be one-for-one nor does it need to involve similar properties; e.g., you can exchange two or more residential properties for one commercial property or vice versa.

We have been involved in hundreds of 1031 exchanges. At any given time, we usually have several such transactions in escrow. Most of our 1031 exchanges involve a disposable property on Oahu (often a former home) being exchanged for replacement property on the Mainland. In about a third of the transactions, the exchanger is purchasing a replacement property they plan to rent for awhile and then convert into a new home; i.e., they are exchanging the equity they have in their Oahu property for a future home they plan to use themselves.

The IRS mandates that a completely independent third party, commonly referred to as Qualified Intermediary (QI), be used in a 1031 exchange. The following steps have been changed; however, they help explain the role of the QI. The QI takes title to the disposable property for a brief instant in the process of having it sold from you to the buyer. Similarly, the QI takes title to the replacement property for a brief instant in the process of having it sold from the seller to you. Therefore, the QI has owned both properties and can exchange one for the other. In 1991, the real estate industry successfully lobbied Congress to have the law changed, as escrow companies were charging double escrow fees; i.e., seller to QI and then QI to buyer. Now, the QI no longer has to take title to both properties, however, they are tasked to provide instructions so that both transactions are handled according to IRS instructions.

To defer all your capital gains taxes, you must buy replacement property that is equal to or higher in value than the disposable property. You must also reinvest all the cash proceeds from the sale. You cannot have access to any of the proceeds from the sale of the disposable property or those funds will be taxable. The QI maintains the funds from the sale of the disposable property and then makes those funds available in order to enable the purchase of the replacement property.

Most 1031 exchanges are delayed exchanges where the disposable property is sold prior to purchasing the replacement property. There are some rules that need to be followed; however, the rules for most one-to-one exchanges are quite clear and straightforward. Over half of our exchange transactions involve absentee owners conducting their first exchange. Their Oahu property is often a former home they bought years ago or a family home that was inherited. The former home was held on to over the years with the idea that family members might someday use it.

Each week we talk to newsletter recipients about 1031 exchanges including, in most cases, estimating their capital gains taxes were they to sell without conducting an exchange. Many owners overestimate the taxes that would be due were they to sell without conducting a 1031 exchange. Often, they subsequently decide it makes more sense for them not to conduct an exchange and pay the taxes.

If you’re interested in such a conversation, contact us with a couple of preferred times and your telephone number(s) or call me toll-free at 1-800-922-6811. The following items should make the conversation more meaningful: (1) Read our 1031 paper as it should answer many existing questions and often triggers some new ones. (2) Note the figure on line 20 (Depreciation Expense) of the Schedule E (Supplemental Income and Loss) to your last 1040 federal tax return. I can estimate your taxes much more accurately if I know how you have been depreciating your property. Three of the more common discussions topics are:

(1) Finding a QI, cost, etc. The physical location of the QI is unimportant. For a simple one-for-one exchange, the cost should be about $750. We’ll provide you some QI recommendations.

(2) Tips to help you locate replacement property. We’ll provide you input depending on the time you have available for searching including what to do if you have no search time available.

(3) Sequence of events. We’ll provide you a series of suggestions and recommendations to help you conform to the various timing requirements.

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