Guest Blogger Scott Ellsworth CPA: Pay Taxes or NOT? 1031 Exchanges Make It Your Choice!
What are the consequences of selling that property you have held for 15 years? You may walk away with some cash, assuming you haven’t refinanced the property. If you have refinanced the property and taken cash out, you may find yourself owing more in taxes than you get when you sell. By the time you’ve paid off the mortgage and paid all of those taxes the government wants, it could literally cost you to sell your property.
Why? Because the depreciation deduction that you take on a rental property is really just temporary—you get to write it off while you own the property but you have to “recapture” it when you sell.
We all know that for the most part your property doesn’t really depreciate over time. Meaning it does not go down in value. We plan on the property to go up in value.
Well, since it really did not depreciate, the IRS wants you to return the deduction. So in addition to the capital gain on the property (Sale Price less the purchase price and any improvements you did) all the depreciation has to be added back to income (or recaptured) when you sell the property.
If you have held a property for all its depreciable life (27.5 years for residential rentals) then basically the entire sales price, less sales expenses will be taxed. That means that if you have refinanced at 80%, I hope you have kept some of the cash from the refinance. You may very well need it after paying closing costs and the income taxes.
There is help, though: a section 1031 exchange provides a way to defer the tax on that gain. You can exchange the property for another larger property or multiple properties. Any cash or net debt relief would be taxed if you get any. It is important to structure the selling of your existing property and the purchase of your new property correctly. There are lots of rules and you will need an independent, trustworthy intermediary to handle the transaction as nothing can flow through your hands. Your tax return filing for the year is critical as well.
A section 1031 Exchange is a great vehicle to defer, or possibly eliminate taxes, on your property. It allows you to use all of your equity in your existing property to buy something bigger instead of paying taxes each time you move up which reduces what you have to invest.
Scott Ellsworth is a CPA specializing in real estate taxation and accounting. He assists clients all over the country with proper tax compliance and planning for real estate transactions. He can be reached at firstname.lastname@example.org