Do I understand the nature of tax advice?

What follows is not tax advice. It is simply an overview of some of the federal tax rules affecting real estate investment property. It covers some tax breaks that may be available. Do not rely on this material. For tax advice you need to consult with a tax professional, such as an accountant or tax attorney.

Do I understand profit and loss from a tax perspective?

All of us want to make a profit. However, when we do make a profit, there’s generally a tax to pay on it. Of course, with investment property you may be able to defer that tax through a “tax-free” exchange. Or you may be able to convert your property to a personal residence and get up to a $500,000 exclusion on capital gain for married couples filing jointly. If you have an investment property loss, you may be able to offset it against other investment property gains, or take it slowly against your personal income. Interestingly, if you show a loss on a personal home, you cannot deduct the loss. 

When do I owe taxes?

You owe taxes when you realize a gain, basically when you sell. No matter how high the value of your property goes, you don’t pay capital gains tax on the profit so long as you continue to own the property. You would, of course, owe income taxes if you showed excess income over expenses on an annual basis, and you would also owe property taxes.

Can I avoid taxes by trading my investment property?

You may be able to trade or exchange your investment property for another and defer the capital gain from the old property to the new. This is technically called a Section 1031 (a)(3) tax-deferred exchange. Many investors use this as a means of multiplying their profits. They hopscotch from property to property, increasing the value of their real estate holdings unencumbered by paying taxes on the gain for each transaction along the way.

Is a Section 1031(a)(3) tax-deferred exchange complicated?

Not exactly, but it is tricky. You would be wise to have a professional handle it for you until you know the ins and outs. The rules for a tax-free exchange were greatly simplified over a decade ago by several tax cases, the most famous of which is called the “Starker rule.” Under Starker, you sell your investment property as you would otherwise.

However, you have 45 days before or after the sale to designate a new property into which you will invest your money. And you have 120 days to close the deal on that new property. (You can designate an arm’s length entity—one that you cannot touch—such as a title insurance company escrow account to hold your money from the sale until it’s ready to go into the new property.)

Of course, there are other conditions of the exchange that must be met. One is that you may not take any cash out (”boot”) as part of the sale. (If you want cash out, you must  usually refinance  the  old  property  before  the exchange, or the new property after it. Another condition is that only “like kind” properties can be exchanged. This means that the property must be held for business or investment. It does not mean that you can only exchange, for example, an apartment building for another apartment building.  Any real  estate held  for  investment (house, apartment building, lot) can probably be exchanged for another.

What is the tax exclusion I’ve heard so much about?   

After living in a property for a period of time (you must reside in the property for two out of the previous five years), you may then be able to sell the home and reap the benefits of the principal residence capital gains exclusion. It is up to $500,000 per married couple filing jointly, or up to $250,000 for individuals. It has some other conditions, however. For us the most important is that the property must be your principal residence. It cannot be investment property. The residence rule is strict. Thus, for an investor, this exclusion has limited value. Also, you can only do one of these exclusions every two years.

Can I convert an investment property to a residence and then take the exclusion?

Possibly. It has been done by investors. What you would need to do is to move into the rental property and reside in it for at least two out of the previous five years (assuming you hadn’t previously done a tax-deferred exchange on it). Then, after the time period was up, you could sell it as a personal residence and take the exclusion.