Last Updated: August 16, 2017By

By Karla Dennis, E.A.

With the real estate market being better than it has been in a long time, many of you may be considering selling your real estate, doing a 1031 exchange or converting a rental to a primary residence.  Whichever decision you make, here is an outline of some of the key considerations to think about when pondering the idea.   Buying , operating and selling a rental property can have profound tax ramifications.

Rental property, if owned for longer than a year or if inherited (1), will qualify for long-term capital gains when sold. This means any gain is taxed at a maximum of 20% with one exception. The exception is recaptured depreciation which, depending upon your tax bracket, can be taxed up to 25%. When it comes time to cash in on a rental investment, there are a number of options available to the owner:

  • Outright Sale – When a rental property is sold outright, the entire gain will be taxable in the year of sale. 
  • Installment Sale – If the seller carries back a note (mortgage) for all or part of the buyer’s purchase price, the seller qualifies for installment sale treatment, which in effect spreads the taxation of the gain over the life of the note.(2)
  • Convert to Personal Use – The rental can be converted to the personal use of the taxpayer and any gain deferred until the property is ultimately sold.  
    • Tax-Deferred Exchange – A tax-deferred exchange can be used as a means of avoiding immediate taxation on the gain from a rental property by deferring the gain into a replacement property.(2) Business or Investment Use Requirement – To qualify for a Sec 1031 exchange, the properties exchanged must both be held for business or investment use. Like-Kind Requirement – The properties exchanged must be like-kind (similar in nature, but not necessarily of the same quality). Real estate must be exchanged for real estate (improved or unimproved qualifies).Caution: Sometimes real estate is held in a partnership or other entity. Generally, an entity ownership does not qualify as like-kind. Although, tenant-in-common interests (sometimes referred to as TICS), if structured properly, can. Property Acquired with Intent to Exchange – If a taxpayer acquires (or constructs) property solely for the purpose of exchanging it for like-kind property, the IRS says that the taxpayer doesn’t hold the property for productive use in a trade or business or for investment, and as to the taxpayer, the exchange doesn’t qualify for non-recognition treatment under Code Sec. 1031. Simultaneous or Delayed – The exchange can be simultaneous or delayed. If delayed, the property received in the exchange must be identified within 45 days after the property given is transferred. No matter how many properties are given up in an exchange, a taxpayer is allowed to designate a maximum of either:

      (a) Three replacement properties regardless of FMV (fair market value), or

      (b) Any number of properties, as long as the total FMV isn’t more than 200% of the total FMV of all properties given up.

      If a taxpayer identifies replacement properties over these limits, he/she is treated as if none were identified. A taxpayer can, however, revoke an identification at any time before the end of the 45-day time period.

      The receipt of the new property must be completed before the EARLIER of:

      (1) 180 days after the transfer of the property given, OR
      (2) The due date (including extensions) of the return for the year in which the property given was transferred.

      Qualified Intermediary – Generally, to qualify for a delayed Sec 1031 exchange, a qualified intermediary is engaged to hold the funds from the sale until the replacement purchase is made. It is important to understand that the taxpayer cannot take possession of the proceeds from the sale and then buy another property. If that happens, the event does not qualify for exchange and is immediately taxable.

      Reverse Exchanges – It is possible to structure a reverse exchange that complies with the Section 1031 delayed exchange requirements. However, it requires that the replacement property be purchased first, by the intermediary, without the benefits of the proceeds from the property given up in the exchange. Thus, only taxpayers with the cash financial resources can accomplish reverse exchanges.

      Tax-deferred exchanges can be very tricky and should not be entered into without first analyzing the tax aspects.

Whether you decide to sale out right, defer or convert your investment to a primary residence, the key will be to have the right information to make the most strategic decision.  An ounce of planning can provide you with a great return on your investment.  If you are thinking of making a move, implement the right tax plan first by consulting with your tax professional. 

Karla Dennis, Tax Expert & Business Strategist

As seen in Forbes Magazine, Karla Dennis is an expert tax and business strategist. As an enrolled agent, Karla is licensed to represent taxpayers in all 50 states. She holds a Masters in Taxation and Business Development and is the author of two books, Tax Storm and Against the Odds.

Karla, founder of consultancy firm Karla Dennis & Associates™, has saved her clients thousands of dollars and has been featured in various media outlets such as Forbes, MSNBC, KTLA, Yahoo! Finance, and SmartMoney, marking her as the ultimate tax expert.



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