How to Sell Rental Property and Not Pay Capital Gains

1031 exchanges let you sell rental properties without paying tax.

1031 exchanges let you sell rental properties without paying tax.

Selling rental property for a profit can be a taxing experience. Your profits above what you originally paid for the property are subject to capital gains taxes, while any depreciation that you claimed gets recaptured at a 25 percent tax rate. However, if you plan to use the proceeds of your sale to buy more real estate, you can structure the whole transaction as a Section 1031 tax-deferred exchange. In a 1031 exchange, you defer all of your taxes until you some day sell your real estate for cash instead of swapping it for more real estate. To maximize the benefit of the 1031 exchange, you have to get started early. In fact, it's best to have your 1031 exchange structure in place before you place the building you're selling under contract with a buyer.

Hire a 1031 exchange facilitator, called a qualified intermediary or QI. To make your exchange legal, the Internal Revenue Service requires you to have a third-party intermediary to hold all of the money from the sale of your property. If your intermediary is not in place before money starts changing hands, you could have to pay capital gains tax on it. The QI industry isn't regulated, so make sure that you choose a good one. Your attorney or accountant should be able to recommend a reputable intermediary.

Insert special language, available from your QI, into your purchase agreement when you find a buyer. The language informs the buyer that you intend to do a 1031 exchange and binds them to support you in your exchange by executing the special paperwork that your qualified intermediary will require. It also protects them from liability for your decision to do an exchange.

Look for replacement properties before your sale closes. The IRS will only give you 45 days after your property closes to send a list of a limited number of properties that you want to buy to your intermediary. If you don't send the list, you can't do an exchange. If you send the list too late or if the property you want to buy isn't on the list, you can't exchange, either.

Identify properties that will require you to spend all of your proceeds from the sale and have at least as large a mortgage as the property that you are selling. If you do not spend all of your money and take out as much debt as you had before, the IRS will tax you on the difference, which is called boot.

Send your identification list to your intermediary no later than 45 days after your sale closes. The IRS lets you choose three different identification methods. Under the three-property rule, you can list three properties and buy any one, two or all of them. Alternatively, you can use the 200 percent rule and list as many properties as you want and buy as many or as few as you want as long as all of the properties on the list don't add up to more than twice the value of the property you're selling. Finally, you could also choose to use the 95 percent rule. This rule lets you list as many properties as you want as long you end up buying enough properties from the list to correspond to at least 95 percent of the total value.

Close on your replacement property within 180 days or less of the sale of your previous property. At this time, the QI will use the money that he was holding from the sale to buy the new property and transfer it to you.

Tip

  • Your capital gains are calculated based on your adjusted cost basis, not your purchase price. To find your adjusted cost basis, add your purchase price, the closing costs you paid when you bought the property, and the cost of any improvements that you made to the property together. If your net selling price isn't more than your adjusted cost basis, you won't owe any capital gains taxes.

About the Author

Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.

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