Maryland Real Estate Wealth: The 1031 Advantage - 03/05/24

How can you sell your beach property and not pay capital gains tax?

That is what Ryan Haley is discussing in this week's podcast. 

Many of our clients come to us with that question. And when they're thinking about selling the property, one of the main questions, objections, and workarounds that they need to think about is not only what are they going to be able to sell their property for, what are the costs of sale, but then ultimately at the end of the day, what is the tax liability that they may face by selling their property?

Capital gains tax is an interesting animal, and it's something that, truly, you can't completely avoid or get around. But there are ways to possibly defer your tax liability from one property to another property, so ultimately you would not have to pay the capital gains tax upon the sale of the one we're discussing now, which could be your beach property.

So let us start with any property in general. If you own a property in any state and it is your primary residence, and say you've lived there for a number of years and that property has gone up in value, so you have your purchase price that you originally paid and then it's gone up in value to what it's ultimately worth today. And that increase in value, some may refer to as your equity in the property, but it also could be your gain in the property. And that's what comes into consideration when you're calculating your capital gains.

And the general rule of thumb is if you're selling your primary residence and you are single, selling that primary residence, you have a $250,000 exemption when it comes to paying capital gains. So for simple numbers, if you bought a property and you paid $100,000 and it has now gone up $250,000, it would be worth $350,000 today. You sell it for $350,000, and ultimately you would have a gain of $250,000. As a single person selling your primary residence, that full gain of $250,000 is tax-free capital gains, tax-free.

Now if you are married, joint filing a joint tax return, and it's your primary residence, you are exempt for up to $500,000 in capital gains. So there are other calculations that come into play. It's not as simple as you bought it for 100, you sell it for $350, and there's $250,000. It's actually less than that because you can subtract your closing costs when you're selling it today. You can add back in your closing costs from when you purchased it, and there's the possibility that you have some capital improvements that can be added in there as well, which ultimately reduces the total gain.

While we are not a tax adviser, what we want to do is help you be able to make an informed decision about your ability to sell your property and investment strategies for the next one. So up to this point, we have talked about primary residence. What we want to focus on now is a second home and/or an investment property.

How Does 1031Tax-Deferred Exchange Work?

So technically, there is a way to be able to defer your capital gains tax for an investment property, something referred to as a like-kind exchange. Originally, people had called it a Starker exchange, and then it was referred to as a like-kind exchange or investment to investment exchange. And what we commonly hear it referred to is as a 1031 tax-deferred exchange. And ultimately what happens is if you own an investment property, say here at the beach, it's a property that you purchased 20 years ago, and it doesn't matter if it's 20 years or two years, but as long as this was an investment property, you could sell it and repurchase another investment property. So it's a like-kind exchange from investment to investment. And instead of paying capital gains tax because remember once again this is not your primary residence so you do not get that exemption of $250,000 for a single entity and or $250,000 for a single person or $500,000 for a married couple filing a joint tax return you do not get that unless it's your primary residence.

So if this is an investment property you purchased it in Ocean City and you did some renting of the property, did some vacation rentals, maybe you did a year-round rental for a period of time, you could sell that property and take the gain that you have in that property and roll it into a replacement investment property. And by rolling the gain into an investment property, the next investment property, the replacement property, you would not be subject to paying your capital gains tax upon this sale but instead deferring the capital gains tax to the next property.

Now there are some very key timelines and things that you need to do to make sure that you properly qualify for the 1031 tax-deferred exchange. Let's start off with when you and the agent have a conversation about selling your property. One of the first things you want to talk about is the fact that you're going to be selling and you've heard about this thing called a 1031 tax-deferred exchange and or you'd like to purchase another property with the proceeds of the sale from this property. Those are key things that you're going to want to bring up when you're discussing it with myself and or your agent. Then what we're going to start to do is we're going to talk about your unique situation.

The agent is going to ask how long have you owned the property. Did you rent the property out? Did you depreciate the property over the last few years? If you rented it out, did you actually claim the rental income on your taxes or was this something you know that you did with family and friends? Do you have an accountant, do you have a CPA that may have helped you with your taxes over the years? Those are all things that your agent will try to get information on to start putting the puzzle together to ensure that you would qualify to be able to conduct the 1031 tax-deferred exchange.

Now who does this? Well, the answer is a lot more people than you may think, and we have a lot of people who started in Ocean City, this might have been their first investment and now they want to get to Florida, they want to get to the Carolinas, they want to move on to something different, and or maybe they want to buy another property in Ocean City.

So they could have started in Ocean City, bought a little one-bedroom property, it was a great starter property, it's gone up in value, and now they, the family has grown, they want to move to a two-bedroom or a three-bedroom and they can sell that one-bedroom and now roll the gain into the next one.

So it is complex, but there are ways to do this to avoid having to pay that capital gains tax on this sale.

There are some key timelines that should be pointed out if this is something you're going to want to do. Once again, we're going to have that conversation, we're going to list the property, and we need to include an addendum that notifies the prospective buyer that the seller intends to enter into a 1031 tax-deferred exchange at no cost to buyer. Basically, it's an addendum, they are part, they're just notifying them that they are part of the 1031 tax-defer exchange. They have to cooperate and sign all the documents but it doesn't cost them anything, we just have to let them know.

Then once you ultimately get under contract, we have to make sure that that addendum is included. We will then need to notify your third-party intermediary, this is key because the third-party intermediary, and there are companies that do this, there are attorneys who handle this and I can point you in the right direction to help you get connected with that third party intermediary, we need to notify them that we have a contract and notify them of when the settlement date is because what's going to happen is when your sale closes, you're under contract, we're moving forward to settlement, we have inspections, we have the condo docks, we have financing, and ultimately it's settlement day for the property you're selling. That fund that you intend to not pay capital gains on cannot be touched by you. It has to be put into the hands of the third-party intermediary who holds that money until you ultimately go to settlement on the replacement property and they transfer it over.

So the key is you can't touch those funds, you can't go to settlement and collect the money and say, "Oh, by the way, I wanted to do a 1031." It doesn't work that way. It has to be identified when you have the contract but to be safe when we had that initial conversation, we need to talk about it.

So you've gone to settlement, the money is now being held with an intermediary. A lot of our clients, prior to even going to settlement, are out looking for the replacement property, they want to find where they're going to roll their funds into to make sure that this all works out with the 1031. But some actually will go to settlement and once they've gone to settlement, from the date they close, they have until midnight of 45 days later to identify the replacement property and you can do so up to three properties that you can identify but they need to be identified within that 45-day window.

From there, once you've identified them, you have a total of 180 days. So it's midnight of 180 days to actually successfully close on that property. And at that point, when you go to close on that property, your intermediary is going to take the funds that they're holding and transfer them to the title company that's handling settlement and in many cases, that seller who has now become the buyer of the replacement property will either bring additional funds and pay for the property in full cash or they can combine those monies being held in escrow with a mortgage. It just depends on what the cost is of that new replacement property.

So that is the 1031 tax-deferred exchange in a nutshell, a very high-level conversation about the basics of what a 1031 tax-deferred exchange could look like.

You could sell your property in Ocean City and buy in Delaware, you can buy in South Carolina, you can buy in Florida, you can buy wherever, but there are some items that come into play when it comes to qualification. It has to be investment to investment. If it was a straight second home and it was never classified as an investment property, you are going to have a hard time justifying it as a 1031 potential property where you're going to buy a replacement property that is investment.

Additionally, there are requirements as to the property price that you are replacing. So the price of the property that you are buying needs to be equal to or greater than the gain amount that you've had with the property you've sold. So there are some ins and outs to this. The best recommendation would be is we have an initial conversation about this, but then we also need to bring in your accountant and or your CPA and a third-party intermediary who can coach you through the steps as to how to set up and complete the 1031 tax-deferred exchange.

So there you have it, that is how you can sell your Ocean City/Beach investment property and buy another property and not pay capital gains tax. If you have any information or any questions about this topic and or any aspect of what it's like to sell your property and buy your property here on the greater Delmarva area, it would be my pleasure to attempt to answer those questions for you and or point you in the right direction if I don't know the answer. So if you like this information, please share it with a friend, subscribe, and I look forward to seeing you back here next week with another edition of the Running Real Estate Podcast.

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