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Real estate investments that appreciate over time can create a hefty tax bill at the time you sell the property. The tax -- capital gains tax -- is the difference between the adjusted cost basis of a property -- its purchase price minus the cost of improvements and costs you incur during its sale -- and the selling price. Although the IRS does not provide a capital gains exemption for a real estate investment sale like it does for the sale of a private residence, the IRS does provide a way for you to avoid the tax by transferring capital gains to new property.
Capital gains on tax real estate investments are due in full in the year in which you sell the property. If you are selling with the intent to exit the real estate investment market, the tax is unavoidable and you have no choice other than to pay the bill in full. However, if you are liquidating a real estate investment and plan to purchase another, you can put off paying capital gains tax by taking advantage of IRS Code Section 1031 and rather than selling your property, exchange it for a like-kind property.
IRS Section 1031 defines like-kind properties as those “of the same nature or character, even if they differ in grade or quality.” In general, the IRS considers all real estate within the U.S. -- whether improved or unimproved -- as like-kind. You can use Section 1031 to transfer all capital gains to new property if the exchange is pure and money does not change hands, or transfer a portion of capital gains to new property if in addition to an exchange of property you also receive a sum of money. In this case you will need to pay tax on the money you receive.
Exchanging properties does not require that you set up the exchange in advance. You can get the property ready for sale, list and sell it and then appoint a qualified intermediary, such as a representative from your bank, to handle and hold the funds from the sale until the exchange takes place. IRS regulations state that a QI cannot be a family member, business colleague or anyone with whom you have a personal relationship. Instead, the QI must be a representative of an independent organization whose only relationship with you is to serve as a qualified intermediary.
IRS regulations identify three main requirements for conducting a 1031 like-kind exchange. First, the exchange must be an investment-to-investment or business-to-business exchange. You cannot, for example, exchange your investment property for a private residence. Second, you have a 45-day window from the day your sell your investment property to find another and produce a written sales agreement. Third, you must complete the transfer and close the deal within 180 days of either selling your investment property or by the date you file your tax return for the year. Whichever occurs first is the time frame that applies.
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