Ask Phyllis: a blog series of frequently asked real estate questions. Email us here
Dear Phyllis,
I enjoy your column. But I don’t believe you have yet addressed capital gains tax. My wife and I own a leased commercial (business) property. If we sell this and buy one or two houses or a duplex as a rental property for equivalent value or less, do we have to pay any taxes as capital gain? I am wanting more advice on delaying capital gains. Is there any time limit for the exchange transaction?
LCM
Dear LCM.,
I am a Realtor and not an accountant. As a real estate agent I cannot offer tax advice I recommend that you speak with a tax professional. I did run your question by John Sadd. He is the managing partner of Sadd, Higashi, and Shamma, a Glendale accounting firm and he advised the following. What you are contemplating is called a “Tax Deferred Exchange” under Section 1031 of the Internal Revenue Code. What you accomplish by qualifying your transaction as a Tax Deferred Exchange is that you can delay the income tax (or as people tend to call it Capital Gains Tax) until a later date.
First, to qualify, the properties traded for must be “like kind’ to the property received. The IRS has a very broad definition of “like-kind” here- and your business property would be “like-kind” to residential rentals.
For the gain to be completely deferred, the amount you invest in the new property must be at least equal to the net sales price of the property sold. If you have a loan on any of the properties you need to be careful that you do not take any cash out of the sales proceeds. This keeps your transaction fully tax-deferred.
If the property you acquire costs less than the net sales price of the property you sold, some of the gain will be subject to taxes.
The proceeds from the sale must be transferred directly from the sales escrow to an “Accommodator.” Your Realtor® or Escrow Company would be the best source for recommending one. The Accommodator holds your funds until they are needed to buy your replacement property. Ask ahead of time if they will pay you interest on the funds on deposit. Remember, the Accommodator must hold the funds. If you withdraw any funds they will become taxable.
There are some “etched in stone” dates to be aware of. On or before 45 days after the closing of the sale of your property, you must identify to the Accommodator the property you intend to acquire. Then, you must close the purchase of the new property 180 days after the date of the original sale. There are other steps that your Accommodator will walk you through. There are no extensions to these dates available.
You may do an exchange that allows you to purchase the replacement property before the sale of your property. But we won’t tackle that here. Remember, the exchange only delays the tax. If you sell the new property you may have to pay tax on the original gain as well as the gain on the sale of the new property.
This is a very general discussion of a complicated subject. Always consult your own tax advisor before attempting a Tax-Deferred Exchange.
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