Updated: May 3, 2013 12:14PM
Originally published: June 27, 2005
There’s a problem with the current real estate boom: what to do with those profits! All those gains just create more money to chase real estate prices higher.
But what happens when you want to get off the merry-go-round and just put some of that real estate money in the bank? Suddenly you have to worry about taxes taking a bite of your profits.
But there are some exemptions, exclusions, and opportunities to minimize taxes on real estate profits. And, of course, there are risks to those strategies if you don’t follow the rules -- or if you are taken in by an increasing number of real estate tax ripoffs.
Taxes on residential real estate gains are pretty straight forward. If you’ve lived in the home for longer than two years, you are entitled to exclude the first $250,000 of gains. If you own a house jointly, you can exclude $500,000 worth of gains over the cost of the home.
(Remember, you can increase that cost basis by adding in any major structural improvements made to the home, but not cosmetic changes like paint and carpeting.)
Capital gains tax
Any remaining gains over the $250,000 per owner exclusion are taxed at capital-gains rates, which may be as low as 5 percent or as high as 15 percent depending on your tax bracket. If you’re selling your personal residence, you can no longer roll over gains into the cost of a new residence, as was once the case.
For most people the $250,000 exclusion rule is a big tax break. And you can use it again in two years if your next residence is sold for a profit. Only homeowners who have lived in the same home for many years and seen huge gains, or those who purchased multi-million dollar houses that appreciated in value, face a big tax burden.
If you turn your residence into an income-producing property by renting it out for at least a year and a day, you may have some interesting tax-deferral opportunities. Those same tax possibilities have fueled the boom in real estate investment properties.
For real estate investors, the IRS has created a section of the tax-code that provides for a 1031 exchange of real property, without paying taxes on the gains. But as 1031 Exchange expert Gary Gorman explains in his new book, Exchanging Up! (SuccessDNA, $24.95), you have to be very careful about following all the rules.
A 1031 exchange allows you to roll the gain from the sale of one real estate property into another, if you identify the new property within 45 calendar days from the sale of the old, and complete the transaction within 180 days.
One other key ingredient: You cannot take control or receipt of the money from the sale of the original property (much as you cannot take money from a 401k distribution before it is rolled into an IRA). The exchange must be handled by a qualified Intermediary who will facilitate the transaction.
If the IRS finds you failed to follow all the rules exactly, it will disallow your exchange, demand you pay taxes, interest, and penalties -- and may even charge you with fraud!
The process is complex, and Gorman’s firm is one of the largest in the country handling exchanges in every state. At his Web site, www.expert1031.com, he points out many of the pitfalls.
For example, he advises making certain that your Intermediary holds the profits from your sale in an individual account for your benefit until your next purchase is closed, instead of commingling funds of many clients.
And Gorman warns against TICs (tenants-in-common) -- a growing new real estate concept made possible by the 1031 tax provisions. These are essentially unregistered “funds” or “partnerships” into which you exchange the profits from your property sale. The TIC purchases one or two large properties, and promises a stream of income with no management responsibilities.
Only one TIC has been tested and approved by the IRS, which has stringent requirements that ownership of the property must be individually deeded among the group, and that sale, refinancing, or leasing must be unanimously approved by all part-owners.
Gorman suggests that if you want to do a 1031 exchange of real estate, you find a broker to identify a suitable property and handle negotiations.
Never be afraid to get expert advice to use the provisions of the tax code to your advantage. But never fool yourself into thinking you can fool the IRS! That’s The Savage Truth.
Terry Savage is a registered investment adviser. Distributed by Creators Syndicate.