In 2018, with the passage of the Tax Cut and Jobs Act, tax-free 1031-exchanges are limited only to real-property. Each taxpayer is allowed $250,000 of gains for their primary residence (having lived in the property for 24 out of the past 60 months), but investment property is treated differently. Real estate investors can still trade “like-kind” investment properties tax-free: Sell one property, and then buy another of equal or greater value, and avoid capital gains tax.
Real estate investing is all about cash flow. For example, in order to increase your rental income/cash flow (not subject to self-employment tax!), you may be ready to trade your equity in your single-family rental home for a 12-plex, and double your monthly cash flow.
The rules of a 1031-exchange are fairly straight-forward, but the execution is anything but. You need to have a 1031-exchange company on-board, as well as your tax-preparer. Any cash taken at closing of the sale is subject to tax, and considered all taxable gain. However, if you leave all proceeds in escrow, and flip that money to the next investment property, you can carry over the tax basis of your original investment to the next property, delaying the tax on the gains. You’ll need to identify your next property purchase within 45 days of sale, and you’ll need to close on it within 180 days. You cannot live in the exchange purchase for at least two years to satisfy the exchange rules of “like kind,” and avoid tax.
With some up-front planning, there are some tricks to consider—and planning the exit strategy is where we come in. Some clients plan to leave their investment properties to their heirs, who will get a “step-up in basis”, which means all unrealized gains vanish upon the death of the investor. It works the same with stocks. One problem with this plan is that real estate is not as liquid as stocks, and some heirs will want to fix up the property (spend money), some will want to keep it, and some will want to sell it immediately. We hope to avoid family quarrels, so we have some other ideas for you. One includes moving into the property after two years, which will begin to reduce your taxable capital gains as it becomes your primary residence. There are nuances we must discuss, but you get the gist.
Another solution we have is called an Up-REIT, where your property is exchanged by a Real Estate Investment Trust, and you’re given shares in return. Those shares are not taxable until sold by the original investor. If heirs inherit the REIT shares, they are tax-free, and each heir can decide when to sell. Better yet, you can manage your tax (couples that make less than $100k pay 0% federal long-term capital gains tax!) and sell off portions of your REIT shares each year to stay in the 0% long-term capital gains tax bracket. If you’re thinking of real estate investing, we can help as part of our financial planning service — just reach out to chat!