TAXING TIMES, DECEMBER 2014 EDITION
By Rick Torkelson, CPA and principal of Torkelson & Associates, LLP in Petaluma, CA
Last month, we demonstrated how to report a gain from the sale of our property rental in the installment basis. This month, we will show the tax effects of a Tax Deferred Exchange AKA 1031 exchange – named after the IRS code section with all the rules.
Here is a summary of the situation:
To purchase the rental, we put down $100,000 and financed $300,000. Our out of pocket rental expenses equaled our rent income. We made payments on the $300,000 mortgage for 10 years. After 10 years of payments, the balance of this loan would be about $244,000. We wrote off $11,000 of depreciation every year for 10 years saving us about $22,300 in taxes over those 10 years. We sold the property after 10 years for $550,000 paying $27,500 to sell it. The taxable gain on the house was $232,500 (all long term capital gain) and the income tax on our gain was $56,500.
Here is a recap of the cash we have after these facts:
Sales Price: 550,000.
Pay-off Loan: <244,000>.
Cash After Sale: 278,500.
Income Tax: <56,500>.
Net Cash After Tax: $222,000.
Tax Deferred Exchange
Exchanges are not for everyone. Whenever one of my clients is selling a property and asks me if there is anything they can do to lower the tax, I ask them “When the escrow closes, what do you plan to do with the money?” If their answer is to buy another property, then an exchange just might work beautifully.
You don’t get any cash or pay off any debt when you exchange unless you are prepared to pay tax on the cash and the reduction of debt. What you do get is the ability to put all your proceeds into another property without the erosion of income tax.
Yes all the taxes on a sale like the one illustrated above can be deferred, but it is a deferred exchange, not a tax free exchange. To completely avoid the taxes in the year of sale ($56,500 in our example), you must buy a property for at least your sales price less your sales expenses $522,500 (550,000 less 27,500) in my example.
One scenario that comes up from time to time is “I’ll buy a cheaper property with all my proceeds, $278,500, and not have any payments.” This is a disaster – All your proceeds went into the new property, but your $244,000 mortgage is gone – This scenario will tax the entire gain, $232,500, and you will have no cash from the sale to pay the tax. Reducing your debt is taxed just like getting cash out of the sale.
ADDITIONAL HOOPS TO JUMP
It is critically important you do not have access to your sales proceeds during this entire exchange. To accomplish this, you must use a professional “exchanger” or “facilitator” to make this exchange. You must have your exchange property identified within 45 days from the sale of your property and you must close the target property within the earlier of the due date of your tax return or 180 days.
I keep writing tax deferred exchange – this has to do with basis or cost of the new replacement property. If an exchange is accomplished where the entire gain ($232,500 in our example) is not currently taxable, the cost of the new replacement property is affected. Simply stated, what the IRS rules require is that you must subtract the untaxed gain ($232,500 in our example) from the cost of the replacement property. If the property really cost 600,000, then for tax purposes, it costs $367,500 (600,000-232,500). And it is $367,500 that we depreciate and report as cost of the property if it is ever sold.
The very best thing you can do is to consult with a tax professional before you put your rental property on the market.
Read more about tax on the sale of rental property in part 1.