Capital gains tax may be due when real estate is sold for a profit after one year of ownership. Primary residences are tax exempt for realized gains up to $250,000 for single and $500,000 for married couples if the owner has lived in the property for two of the last five years. Investment properties have no such exemption. The capital gains rate for singles in 2021 is as follows:
O% if taxable income is less than $40,401
15% if taxable income is $40,401 - $445,850
20% if taxable income is greater than $445,850
As you can see, the capital gains tax rate is lower than personal income tax rates. But what if you can indefinitely defer paying that tax? Why not use that tax money to purchase another property, pay medical bills, or have a great vacation? If this sounds good to you, keep reading.
Section 1031 of the IRS Code allows the capital gains tax to be deferred if the investor follows some easy but strict rules.
The investor uses a Qualified Intermediary to hold the proceeds of a sale in escrow for a maximum of 180 days, during which one or more like-kind replacement properties are identified and purchased.
Real estate like-kind properties include the exchange of residential, commercial, and vacant land. For example, sell a single-family property and purchase a vacant lot, duplex, or warehouse. Mix and match as desired.
Within 45 days after closing, the investor must provide the intermediary with a list of replacement properties. This list can include 1-3 properties regardless of value OR any number of properties as long as their aggregate value doesn’t exceed 200% of the relinquished property’s value.
If the sales of the replacement properties don’t occur within 180 days after the closing of the relinquished property, the investor loses the opportunity for deferring the capital gains tax payment.
Capital gains taxes are due when an exchanged property is sold and not exchanged.
There are a few different versions of a 1031 exchange, but the above Delayed Exchange is the most common. For more information, contact a real estate attorney or CPA.