There are two general paths that you can take when it comes time to sell your investment property. One is to defer capital gains taxes and invest all of your gains into another property. The other is to cash out and do whatever you like with the money from your investment property sale. But for that flexibility, you’ll have to pay taxes on capital gains. In this article, we’ll look at both options so you can decide which may be right for you.
1031 Exchange Vs. Paying Gains Taxes
If you can meet the 1031 Exchange requirements as laid out by the IRS, you’ll have more capital to roll over into another investment property since you won’t have to pay gains taxes. On the other hand, if you aren’t looking for another investment property and want to put your money to work elsewhere, you may decide to cash out and pay your taxes.
If you do decide to cash out, the good news is that you’ll pay long-term capital gains tax rates, assuming you have held the property for more than a year. Expect a 15% or 20% federal rate, depending on your income, as well as state taxes, which can range from 0% in income tax-free states to upwards of 13.3% in states like California. If you have taken any depreciation over the time you’ve held your investment property, you may also be liable for depreciation recapture. Always consult a tax professional when receiving an estimate of your potential tax liability, as it may prove important towards your investment decision.
Going the 1031 exchange route means following a strict set of rules and deadlines to ensure the 1031 exchange is executed properly. Due to the broad nature of what the IRS deems as “like-kind” property, you will have some flexibility in the property types that you can choose from as well. You can decide to go with a direct property, a fractional investment, such as a Delaware Statutory Trust (DST) or Tenant-In-Common (TIC), or a combination of the two. Further, you will not be restricted to a property type or location, which gives you ample opportunity to diversify your holdings.
To get a jump on the 1031 process, start looking at what properties may be available. This will allow you to make more informed decisions without running up against the clock (i.e., 1031 exchange deadlines).
List Your Property
Once you have a few property prospects in hand, it’s time to list your property. Having a few property prospects available means you can start the 1031 exchange process prepared and without being stressed about deadlines.
Find A Qualified Intermediary
Before your property closes, find a Qualified Intermediary (QI) that will hold funds from the relinquished property. The QI should use a segregated escrow account for holding funds. Once the closing occurs, the funds are transferred directly into the escrow account. They should not come into contact with you, as that can void the 1031 exchange.
Identify and Close on A Replacement Property
With the close of your relinquished property, the 45-day clock starts on finding a replacement property. Since you’ve already done most of the legwork here, before your property was even listed, you should have some great options to choose from.
Due to the uncertainty of real estate closings, the IRS has blessed three strategies for identifying replacement property: three property rule, 200% rule, and 95% rule. Once you have decided on the property and identification strategy, it is time to submit identification language to the QI.
After submitting this language, it would then be time to close on one or more of the properties identified. The IRS has allowed investors 180 days from the sale of his or her relinquished property to complete this (which includes the 45-day identification window). Just make sure all of your equity is invested and that you have acquired equal or greater property value in your replacement property to ensure all of your capital gains and depreciation recapture taxes are deferred.
Finding a replacement property can be difficult. Direct real estate isn’t your only option for choosing a replacement property, as DSTs provide a viable alternative to 1031 exchanges. DSTs offer a number of properties bundled up into one package, giving you diversified equity ownership. If you decide to go the DST route, get a diversified investment plan from Realized as part of a wealth management solution.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
1031 Exchange Guidebook
The 1031 Investor's Guidebook