How To Minimize Taxes When Selling Real Estate
With Income, Comes Taxes
Up to now, we have discussed the myriad of ways to invest in real estate but now it’s time to sell our investment properties. As with most cases, if you earn money, you need to pay taxes. I don’t know about you, but I like to keep the money I’ve earned. That’s why I take advantage of every legal tax deduction I have available to me. The goal is to keep my money and to give the government only what is absolutely necessary. Yet again I ask you to run this information by your CPA. They provide advice on if these ideas fit your specific situation.
Since we’ve been dealing with investing, let’s clear one thing up. I do not consider your personal residence an investment. Why? It’s simple, really. You would need a place to live whether you’re investing or not. That’s it. Your personal residence is simply fulfilling one of your basic human needs and, therefore, doesn’t count as an investment. You didn’t purchase it thinking that it would be a source of income for you. It was purchased to provide you and your family with shelter from the elements.
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However, if you live in the home for at least two of the previous five years, you can reap a tax benefit from the sale of your home. A single individual can claim a tax deduction of up to $250,000 on the profits from the sale of their home. Married couples can claim up to $500,000 in deductions. So even if you didn’t technically invest in the real estate market, there are still massive tax breaks available to you, as a homeowner, when you sell.
If you have any kind of investment savvy, you have likely heard of the 1031 exchange, also known as a Starker exchange or a like-kind exchange. Essentially, this is a powerful tax-deferment strategy in which we exchange one piece of property for another. Some of the most successful investors use this strategy.
The exchange gets its name from the tax code that defines it. Section 1031 of the IRS code allows an investor to defer paying capital gains taxes on an investment property when it is sold, as long another “like-kind property” is purchased with the profit gained from selling the first real estate property.
Four Exchange Types
There are four basic types of exchanges and each can be utilized to great benefit if employed in the proper context. Let’s take a look at each one and determine when and how to use them to gain their maximum benefit.
- Simultaneous Exchange
Simultaneous exchanges take place when we sell one property and purchase another on the same day. In order for this to work, the transactions must take place at the same time or else the transaction can be disqualified and may face the full and immediate application of taxes. There are three basic ways that a simultaneous exchange can occur.
Swap or complete a two-party trade, whereby the two parties exchange or “swap” deeds.
A three-party exchange is where we use an accommodating party to facilitate the transaction in a simultaneous fashion for the exchanger.
Simultaneous exchange with a qualified intermediary who structures the entire exchange.
- Delayed Exchange
The delayed exchange is the most commonly used exchange and it does exactly what the name implies. I can sell a property today, hold the proceeds through an intermediary, and then purchase another property at a later date. In other words, the property the Exchangor owns, which is called the “relinquished” property, is transferred first and the property the Exchangor wishes to exchange it for the “replacement” property is acquired second.
Now, to use delayed exchange, you’re required to market your property, secure the buyer, and execute the sale and purchase agreement before it is initiated. Once you’ve done all of this, you must hire a third-party exchange intermediary to initiate the sale of the relinquished property. The intermediary will then hold the proceeds from the sale in a binding trust for up to 180 days while you acquire a like-kind property.
If you use the delayed exchange strategy, you have a maximum of 45 days to choose your replacement property and a total of 180 days to complete the sale of your original property. The length of this timeframe is one of the reasons that a delayed exchange is so attractive to investors.
- Reverse Exchange
Also known as forward exchanges, reverse exchanges occur when you acquire a replacement property through an exchange accommodation titleholder before you identify the replacement property. Now, some of you just read that and are saying, “Justin, hold up! Run that by me one more time.” It seems backward but that’s why it’s called a reverse exchange. You buy first and pay later, much in the same way purchasing with a credit card works.
These can be a little tricky because they require all cash. Furthermore, most banks will not offer loans for reverse exchanges. The reverse exchange follows a lot of the same rules as the delayed exchange but there are a few key differences. For one, taxpayers have 45 days to decide which property they are selling. After that 45 day period, they have 135 days to complete the sale and close out the exchange with the purchase of a replacement property. Failure to meet this 180-day deadline results in a forfeiture of the exchange.