What are the tax implications of selling a rental property and using the profits to purchase another rental property?
I have just sold a rental property and was thinking of reinvesting some of the profit into purchasing another rental property to avoid paying capital gains tax. Does the money need to be deposited into an escrow account or can I deposit into my existing savings account and just complete Form 8824 and identify three properties that I might be interested in purchasing within 45 days?
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Depending on your situation and your desire, there are two broad options each with their own tax implications. The option which allows you to defer taxes on the sale is a 1031 exchange and will require you not to have access to the funds. If you have already sold the house, most likely you will not be able to do a 1031 Exchange, which will leave a taxable sales transaction and reinvestment. In this case, you will likely pay taxes on the profits at 25% to a certain amount, and 15% on the rest. The exact details will depend on the sales price, the amount of depreciation you have taken, and the adjusted taxable basis of the property.
OPTIONS 1: 1031 EXCHANGE
The first option is to do a 1031 exchange and use the proceeds from the existing property to invest in the new property. This is what you are referring to in your question, and it will result in deferring your taxation of your profits until you sell the new property. You cannot deposit the money into an existing savings account, and if you do it will invalidate the 1031 exchange and you will end up owing the taxes. If you have any access to the money, even the option to deposit it into a savings account, the 1031 exchange won't work and you will be subject to the taxes I describe in option 2.
In order to defer the taxes, you'll need to use a qualified 1031 intermediary who will actually receive the funds from the sale of the first property and will use the money to purchase a second property. This can’t be done on your own, and you must use an intermediary to use the 1031 benefit. The IRS is very aggressive about the 1031 exchange rules. This article is a good example of the IRS threatening real estate investors who don't follow the 1031 exchange rules by the letter.
OPTION 2: DO A NORMAL SALE & PURCHASE
The other option is to sell the existing property and pay the taxes on the gain (which actually has advantages). Assuming you sell for a profit, you will pay a 25% tax on any depreciation you've taken up until this point, and then 15% on the profits above this amount.
Although this option won't defer your income, it can still be advantageous from an investment and from a taxation standpoint. One of the downsides of the 1031 exchange is you have a limited window of time to buy the new property. This will make it difficult to find the best possible deal on the new investment property. As a result, you may end up overpaying for the new property to get it done within the window. You also can't downsize the property and use the extra money for a different investment, or diversify the investment either into stocks or into two separate properties.
On the taxation side, while a 1031 exchange will defer the taxes, doing a normal sale and purchase will give you the biggest depreciation tax deduction on the new property. Additionally, you will lock in the taxes at the current rates, which could be advantageous depending on your current tax bracket and your expected future tax bracket.
Get Professional Help
No matter what you decide I would getting help with the process. To do the 1031 exchange you will need to find a qualified intermediary (I and most financial advisors are not 1031 intermediaries). There are lots of them out there and many are very good at helping people through the process. You should definitely talk to one.
From the investment and taxation standpoints, realize the 1031 intermediary has a vested interest in you doing the 1031 exchange and will likely advise you to dp it even if it’s not in your best interests. If you want advice on what is best for you, talk to a fee-only and fiduciary financial adviser. Although most advisers don’t deal much with real estate, some, like myself, have a lot of experience with real estate investing.