Tax-Deferred Real Estate Investments
Real estate is an unusual asset class because the goal is to acquire properties that appreciate in value and have the benefits of the tax deductions for mortgage interest payments and depreciation. Losses can be captured and carried forward to offset future income, which reduces the tax burden.
A popular tax-deferral strategy is to use a 1031 exchange to “trade up” into a similar asset and avoid having to pay capital gains tax until later when cash is taken from the sale of the property. There is a more detailed discussion of the procedures for a 1031 exchange in another blog post.
Besides the more common 1031 exchange, some lesser-known tax-deferral strategies are useful for real estate investors under certain circumstances.
These strategies include:
• 1033 Exchange
• 721 Exchange
• 121 Exclusion for personal residences (replaced section 1034 Exchanges)
IRS – Section 1033
The IRS allows a 103 Exchange for properties subject to eminent domain and those destroyed by natural disasters. Eminent domain is a legal procedure that allows a governmental organization to condemn a property and force the owner to sell it to the government. Eminent domain procedures are used for such projects as building new freeways, construction of government offices, and installing utilities.
Section 1033 also applies to property destroyed by natural disasters such as hurricanes, fires, earthquakes, and so forth. If a property is destroyed, it can be replaced by a different “like-kind” investment. As long as the newly acquired property has more value than the relinquished one and no money is taken out during the acquisition, then the capital gains taxes are deferred.
Property owners are allowed to replace a property that is destroyed by a natural disaster for up to two years after the event occurs. If the property in involuntarily converted through eminent domain procedures, the property owner has up to three years to replace it from the date the eminent domain occurred and was legally made final.
IRS – Section 721
Under this section 721 of the IRS code, a real estate investor can exchange investment property (not personal residences) for shares in a Real Estate Investment Trust (REIT). This is called an “upREIT” transaction. The advantages of contributing property to a REIT and getting shares in the REIT include increased liquidity if the REIT is publicly traded and the ability to sell a portion of the shares during a period that manages the impact of the capital gains taxes in combination with other tax deductions.
A section 721 exchange can be made with a property held by the investor for at least 12 to 18 months, which shows intent for it to be an investment property. Section 721 exchanges are one-way only. This means the real estate investor can exchange real estate for shares in a REIT; however, the REIT shares cannot be exchanged for property thereafter.
IRS – Section 121
Section 121 replaced the previous section 1034 exchange rules. Under the previous 1034 provisions, a person could exchange a primary residence for one of greater value and defer capital gains taxes. The new section 121 rules reduce this, by placing a limit on the capital gains exclusion, which is up to $500,000 in capital gain taxes for those who are married and up to $250,000 in capital gain taxes for those who are single. To qualify for the exclusion, the person(s) must have lived in the primary residence for 24 months during the past five years. The months do not have to be consecutive.
The section 121 exclusion may be taken every two years if the person(s) live in the primary residence for that entire time. This means that capital gains tax liability can be eliminated every two years and never have to be paid if the capital gains are below the exclusion limits when the property is sold.
Summary
Having a general knowledge of these IRS tax rules is important for all real estate investors and property owners. Consult with a qualified tax advisor to learn more about how these IRS rules apply to any particular circumstance.