If you're a high-income taxpayer in the eyes of the IRS during a year when you make a real-estate sale, you may be in for a shock when you file your tax return. Tax rates on long-term capital gains have gone up and may be as high as 20%, plus an additional 3.8% Medicare tax in some cases.
Fortunately, you can defer paying tax on gains from the sale of real estate using one of these two options.
Section 1031 trade
A Section 1031 trade works under a provision under IRC Section 1031 that lets you postpone gains from the sale of business or investment property by using a so-called "like-kind exchange." Don't worry about finding someone willing to trade your property for one you want in exchange. For a Section 1031 trade, that isn't necessary. You only have to reinvest the proceeds from the sale into similar property and follow other IRS rules.
That doesn't mean that a Section 1031 trade can be done as an afterthought. You'll have to plan ahead. Unless you simultaneously trade one property for another, you must use a qualified intermediary to set up the exchange. The qualified intermediary holds your funds when you relinquish the first property, then releases them when you receive the second property.
If the property you acquire is worth less than your original property, you may receive cash or other assets in the exchange. In that case, your Section 1031 exchange can still work. You may have to pay tax on part of the exchange, however.
You can't use a Section 1031 trade for inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets. It also cannot be personal-use property such as a primary residence or a vacation home.
The trade must be for "like" property, although the definition of "like" is fairly generous. For example, you can trade one truck for another type of truck, or an apartment building for commercial real estate. You cannot trade property that is not "like" property, so forget trading equipment for real estate, or property in the U.S. for property outside the U.S.
You must identify the replacement property in writing within 45 days after the date you transfer your property. If you trade like-kind property with a related party, special rules may apply.
Another way to delay paying taxes on capital gains from the sale of real estate is to make an installment sale. Instead of taking the payment for the real estate all in one year -- which can bump you into a higher tax bracket -- you take payments over a period of time.
Taking payments for real estate over a period of time has definite advantages:
You realize your gain over a period of years.
You get a steady source of income.
You also earn interest income.
It can be easier to sell property, especially raw land, when you offer seller financing.
Before you decide, however, consider the potential pitfalls:
The buyer might not keep up the payments. True, the debt is secured. But you still have to collect or take legal action if you cannot.
You can't use your money for other purposes until you receive it.
You cannot use the installment method for inventory or dealer sales, stocks or securities, or a sale for which you have a loss.
Recognizing a gain on the installment method is optional. You can always choose to recognize the entire gain in the year of the sale.
When you use the installment sale method, every payment you receive on an installment sale consists of three parts:
• Interest. You generally must report interest income on an installment sale. If your contract has no stated interest or interest at a rate lower than the IRS minimum, a portion of the gain is assumed to be interest. This prevents you from shifting interest income, which is taxed at a higher rate, to capital gains.
• Gain on the sale. A portion of each payment is allocated to your gain on the sale. You pay capital-gains rates. If the sale resulted in long-term capital gains, the gains are taxed at long-term capital-gains rates for the life of the installment loan.
• Return of your adjusted basis in the property. This is generally the amount you paid for the property, plus improvements and other adjustments. You don't pay tax on the amount of each payment that's just a return of your basis.
Trade vs. installment sale
If you're planning to replace a business property, a Section 1031 trade may be your best bet for deferring gain. An installment sale, on the other hand, may be a better option if you are not replacing the property with a "like" asset.
By planning ahead, you may be able to avoid or defer paying the new, higher capital-gains tax rates and keep your assets working longer for you.