At my CPA firm, I come across a lot of folks who have held rental or investment property for some time and are considering doing a 1031 exchange, typically into markets where they’ll get more bang for their buck in terms of cash flow.
They know that when they sell an appreciated asset, they generally have to pay capital gains tax on the sale, and that they can defer paying those taxes with a 1031 exchange.
In this article we are going to go over the 1031 exchange rules so that you can know how a 1031 exchange works and what the 1031 exchange process is.
We will also go over a 1031 exchange example to show you the numbers behind why a 1031 exchange is such a great tax strategy.
A 1031 exchange is a transaction in which you can sell your rental or investment property and defer all of the tax that would otherwise be due on the sale, including both the capital gains tax, depreciation recapture tax, and state income tax.
Most people underestimate just how much they will pay in taxes when they sell appreciated property.
So let’s first walk through what taxes you would owe if you didn’t go through with a 1031 exchange.
Non-1031 Exchange Example
First we’ll walk through what kind of tax you’d be paying on the 2018 sale of a rental property on which you did not do a 1031 exchange.
For the sake of this example, we’ll assume that you are single, make $250,000 a year at your day job, and take the standard deduction.
So you are in the 35% marginal tax bracket for 2018. We’ll also assume that there are no passive loss carryovers associated with this asset.
Calculating the Gain
Now we’ll walk through what kind of tax you’d be paying on the sale of a rental property on which you did not do a 1031 exchange.
Let’s say that you purchased a property for $400,000. Over the years, you put $25,000 of capitalized improvements into the property. You also took $175,000 of depreciation deductions on the property.
$400,000 + $25,000 – $175,000 = $250,000. This is your adjusted basis in the property.
Now let’s say you sell the property in 2018 for $600,000. You have $30,000 of commissions, closing costs, and other exchange expenses.
$600,000 – $30,000 = $570,000. These are your net proceeds on sale, which we compare against your adjusted basis to calculate your gain.
$570,000 – $250,000 = $320,000 capital gain.
Calculating Federal Depreciation Recapture
To calculate depreciation recapture, we take your $175,000 historical depreciation taken and multiply it by the 25% Unrecaptured Section 1250 Gain rate. $175,000 x 25% = $43,750 depreciation recapture tax.
Note that this 25% rate could be lower if your marginal tax bracket was below 25%.
Calculating Federal Capital Gains Tax
To calculate the capital gains tax, we take your $320,000 total gain and subtract the $175,000 portion that was taxed as depreciation recapture. This leaves $145,000 to be taxed at normal 15% capital gains rates. Note that the capital gains rate is based on your income; if you made less you could be in the 0% bracket; if you made more, you could be in the 20% bracket.
$145,000 x 15% = $21,750 capital gains tax.
Calculating State Tax on Gain
State tax regimes vary.
Seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) do not have a personal income tax.
Other states, such as California, New York, New Jersey, Minnesota, Hawaii, and Iowa have very high personal income taxes.
In our example today we’re going to use California since we see a lot of clients with California property who want to 1031 into other states.
California doesn’t have special capital gains or depreciation recapture rates, so the best we can do is isolate the portion of your total tax liability attributable to the gain on sale.
Using the facts above, your total California taxable income would be $565,764. This is your $250,000 salary + $320,000 capital gain – $4,236 California standard deduction (this is for 2017 as 2018 has not been released yet).
The California tax on $565,764 is approximately $55,700.
Now we will calculate the tax without the capital gain. Without the capital gain, your taxable income would be $250,000 salary – $4,236 California standard deduction = $20,280.
Now we subtract the two tax figures to arrive at the tax attributable to the capital gain. $55,700 – $20,280 = $35,445 state tax attributable to capital gain.
Total Tax Without a 1031 Exchange: $100,945
Now let’s add up all the tax amounts to see what the damage is.
$43,750 Federal Depreciation Recapture Tax
$21,750 Federal Capital Gains Tax
$35,445 State Tax on Gains
$100,945 Total Tax
Wow. $100,945 to the taxmen. That’s a lot of money that you could rather have invested and earned a return on, year over year!
1031 Exchange Requirements
Wouldn’t you rather be able to invest that $100,945 into another property for years to come rather than paying it all today to the IRS and FTB, never to be seen again?
Of course you would.
And you can accomplish this with a 1031 exchange.
In a properly-structured 1031 exchange, you can avoid paying any taxes on your sale this year.
But of course, if you want to do this, you have to do it right.
Here are some requirements if you’d like to defer all taxes in a 1031 exchange.
Now, there are lots of complexities with 1031 exchange — for example, you can do a reverse 1031 exchange where you buy the new property before selling the old property — but for now we will focus on the basic 1031 exchange rules.
You Must Reinvest Your Proceeds Into “Like-Kind” Property
The property you sell in a 1031 exchange is known as the “relinquished property,” and the property you buy is known as the “replacement property.” And yes, you may have multiple relinquished and/or replacement properties!
Regardless, the tax rules say that you must reinvest all of the proceeds from your sale into “like-kind” property.
The good news it that almost all kinds of investment real estate is considered “like-kind” with other real estate held for rental, investment, or business use. (Note that property intended to be “flipped” doesn’t count.)
So you can sell your apartment building and exchange into a commercial building or even raw land.
Note that the property you invest in must be business property, not personal property, such as your primary residence.
(That being said, in some cases, you can combine the 1031 exchange with the home sale gain exclusion. Check out our article How Does the Primary Residence Tax Exemption Work? for more details.)
The Replacement Property’s Value Must Be High Enough
If you want to avoid paying any taxes on your sale, the replacement property must be of equal or greater value than the net sales price of the relinquished property.
You Will Be Taxed on Any Cash You Take Out of the Deal
If you don’t reinvest all your proceeds on the sale of your relinquished property and take some cash out of the deal, this is known as “cash boot.”
Boot is taxable up to the amount of total realized gain on your sale.
Watch Out If You’re Trading Down in Debt
Let’s say that you exchange a property worth $1,000,000 with $400,000 of debt for a property worth $1,000,000 with $300,000 of debt.
Yes, the replacement property’s value is high enough in that it is equal to that of the relinquished property.
But the $100,000 difference in debt would be taxable.
However, this can be offset if you put $100,000 more cash into the deal.
You Must Identify Your “Replacement” Property Within 45 Days of Selling the “Relinquished Property”
In 1031 exchanges, there are two kinds of property. The “replacement” property is the property you’re buying, and the “relinquished property” is the property you’re selling.
Within 45 calendar days of the sale date of the replacement property, you must identify the possible replacement properties you’re interested in buying.
Note that I said “possible.” Yes, you can identify up to three properties worth any amount and only buy one (or two or three of course)! Just remember, you need to reinvest all of your net proceeds.
If you want to identify more than three properties as potential replacement properties, that’s OK too, but if you identify more than three properties, their value cannot exceed 200% of the property sold. If they do, then 95% of what you identify must be purchased.
You Must Close on Your “Replacement” Property Within 180 Days of Selling the “Relinquished Property”
The 45-day identification rule isn’t the only deadline you have to watch in a 1031 exchange.
You also have to actually purchase, i.e., close on your new property (or properties) within 180 calendar days of selling your old property (or properties).
Now, the rule is actually that you must close on your replacement property on the earlier of 180 days or the due date of your income tax return, including extensions.
So if you sell your property between October 17 and December 31, make sure you either purchase your replacement property before April 15 and file your tax return accordingly or you extend your tax return so you have the full 180 days to complete the transaction.
You Must Be On Both Sides of the Deal
The tax return and name appearing on the relinquished property has to be the same as that on the relinquished property.
If you have a wholly-owned LLC, known as a single-member LLC, your LLC is treated simply as you.
You Must Plan Ahead
A 1031 exchange isn’t something you can whip up after-the-fact. You must plan ahead.
1031 Exchange Process
Now that we’ve gone over the basic 1031 rules, let’s talk about the 1031 exchange process, or how the 1031 is actually completed.
Here’s how you actually do a 1031 exchange:
Step 1: Determine if the property you want to sell is a good fit for a 1031 exchange.
Not every property is a good candidate for a 1031 exchange.
For example, if you have significant passive activity losses attached to a property, and those losses will be greater than or equal to the gain on the sale of that property, it may not be a good fit for a 1031 exchange.
You’ll definitely want to have a discussion with your CPA regarding which properties would be a good fit for a 1031 exchange.
Assuming that it makes sense to do a 1031 exchange with the property you’re thinking about selling, we can now move onto Step 2.
Step 2: Start the conversation with a qualified intermediary.
A 1031 exchange qualified intermediary, also known as an accommodator, is a company that facilities 1031 exchanges.
For a straightforward 1031 exchange, you can expect to pay an intermediary $800 – $1,000 for their work.
Step 3: List your property for sale.
You would be doing this anyway without a 1031 exchange, so we’re not going to elaborate on it here as it’s not 1031-specific.
Step 4: Start looking for replacement properties early.
Remember, you only have 45 days from the time you sell your relinquished property to identify potential replacement properties.
And 45 days goes by really, really fast.
Unfortunately, all too commonly I’ve seen taxpayers blow their 1031 exchanges because they didn’t identify potential replacement properties in time.
Step 5: Sell your relinquished property.
This is pretty much the same as in a non-1031 exchange, except now your qualified intermediary will hold the sales proceeds for you in a special account.
It is out of this account that proceeds will be distributed to purchase your replacement property or properties.
Step 6: Identify your replacement property or properties within 45 days of selling your relinquished property.
You will identify these properties to your qualified intermediary.
Step 7: Working with your qualified intermediary, purchase your replacement property or properties within 180 days of selling your relinquished property.
Your funds to close this escrow will come from the account mentioned in Step 5.
However, you may also bring more cash into the deal if need be.
At the end of this process, you’re a lucky taxpayer!
You have obtained for yourself a new rental or other investment property, and you’ve been able to defer all the gain on your old property.
Reverse 1031 Exchanges
Up until this point we’ve dealt with the most common type of 1031 where you first sell your relinquished property and then purchase your replacement property.
You can also do a reverse 1031 exchange, in which your replacement property is purchased before your relinquished property is sold.
It is much more complex than the standard 1031 exchange, oftentimes involving the creation of a separate LLC (called the Exchange Accommodator Titleholder) to take title to one of the properties since you cannot hold title to both properties at the same time.
Therefore, the fees you will pay to a qualified intermediary on a reverse exchange will typically be much higher than the fees for a standard 1031 exchange.
Special 1031 Exchange Rules for California
Wow, 1031s sound great, don’t they? The IRS really threw us a bone on that one, yeah?
Well, if you have any experience with the California Franchise Tax Board, you know that they can be a bit meaner than the IRS.
And true to themselves, they put up another hoop for California 1031 exchangers to go through called the California 1031 clawback.
How the California 1031 Clawback Works
Here’s the California 1031 Clawback in a nutshell: if you 1031 California property into non-California property, you will eventually have to pay California when you sell the non-California property (or a 1031 successor property) in a taxable, e.g., non-1031, sale.
At this point the clawback is triggered.
Let’s run through a basic example to show how the California Clawback works.
California 1031 Clawback Example
Let’s say you buy a property in California for $100,000, all in cash. Selling and expenses and depreciation will be ignored for the sake of this simple example.
After some time, the property is worth $300,000, and you sell it in a 1031 exchange to acquire a property in Idaho worth $300,000, taking a $100,000 basis in the Idaho property and effectively deferring your $200,000 of gain and paying no tax.
A few more years go by, and the Idaho property is now worth $500,000.
If you sell the Idaho property for $500,000 in a normal, taxable sale, you will be liable to pay tax on:
- $400,000 of capital gains to the IRS ($500,000 sales price less $100,000 basis in Idaho property)
- $400,000 of Idaho-sourced gain (same calculation as IRS capital gains)
- $200,000 of California-sourced gain ($300,000 sales price of California property less $100,000 original basis in California property)
So as you can see, both California and Idaho lay claim to the $200,000 of gain that originated in California!
California 1031 Clawback Compliance
In 2014, the California Franchise Tax Board released FTB Form 3840.
Anyone subject to the California 1031 clawback must complete this form not only in the year of their 1031 exchange but in every subsequent year until the clawback is triggered!
And guess what? This form has to completed every year until your California clawback is recognized!
If you fail to file this form when required, the FTB could send you a notice and possibly assess penalties and interest.
Lots of taxpayers and practitioners don’t know about this form and actually don’t believe me when I tell them it’s a requirement, so don’t listen to anyone who tells you otherwise!
Planning around the California 1031 Clawback
Now, the California 1031 clawback can be avoided entirely if you keep 1031’ing up your whole life.
However, if you eventually want to “cash out” in a non-1031 transaction, the clawback can be mitigated by proper planning and use of the California Other State Tax Credit.