Retired Military Officers Likely to Own Rental Real Estate (and a Big Tax Bill)
During the course of a military career, it is likely that you will end up with rental real estate. At least that is the case with a lot of the retired senior military officers I work with. And, due to depreciation recapture (more correctly called 1250 gains) and gains in the value of the property, selling the real estate may result in a pretty big tax bill. You can defer that tax bill by doing what is called a like-kind exchange. A like-kind exchange is where you dispose of one rental property and buy another. The procedures for this exchange can be found in section 1031 of the Internal Revenue Code (IRC) so they are also referred to as 1031 exchanges. Under the current tax code, 1031 exchanges can only be done with real estate.
1031 Exchange Mechanics
If you do want to execute a 1031 exchange you can literally exchange property with someone else or you can do a deferred exchange. In a deferred exchange, you sell your property and buy a new one. As a reminder though, the exchange must be of like-kind property. As 1031 exchanges are now limited to real estate only, that most likely will not be an issue.
The vast majority of 1031 exchanges are executed as deferred exchanges. To execute a deferred exchange, you must follow specific procedures. The IRS is not forgiving when it comes to these rules, so you need to pay attention and get things done right and on-time. The first big rule is that you can never hold the money from the sale of the property. The money must be held by a Qualified Intermediary (QI) and the contract and closing documents for the sale of your property will need to reflect the fact that a QI is involved. Who can be a QI? In typical IRS fashion, they state that a QI can be anyone who is not disqualified from being a QI. They do at least go on to define what disqualifies someone from being a QI. In general, if an individual has acted as your agent within the last 2 years (based on the date you sell the property) that individual is disqualified from being a QI. Just about any professional such as an attorney, financial planner, accountant, or real estate agent that worked for you within the last 2 years would be disqualified. Fortunately, there are companies that provide QI services and you should be able to find one relatively easily.
Once you identify your QI and close on the sale of the house, the clock starts ticking on when you need to replace the rental property to qualify as an exchange. There are essentially two deadlines you must meet.
- You must identify 3 replacement properties within 45 days from the date you closed on the sale of your rental property
- You must close on the purchase of the replacement property, chosen from one of the three identified above, within 180 days of closing on the sale of your rental.
It is worth noting that it is possible to do the exchange in reverse where you buy the replacement property first. Your QI should be able to help you with the rules for that.
What About the Dollars and Cents?
There are a few more rules when it comes to what you can do concerning money and carrying forward the deferred gains from the prior house. As far as the money goes during the exchange, you need to be aware of the following.
- If you receive any cash as a result of the sale (called boot) that cash is considered a taxable gain and you will owe taxes on it.
- If the mortgage on your new rental is less than the mortgage on your old rental, the difference is also considered boot and is taxable.
So, just make sure you don't receive any cash and take out a bigger mortgage than what you have now. Most likely this means you will need to spend about as much or more on the new property (or properties) than you sold the old one for.
Once you own the new property, you'll need to account for the effects of the transaction on the basis of your new property. Basis is a tax term that I'll overly simplify by saying it is what you paid for the property plus improvements and minus depreciation.
When calculating the basis of your new property we essentially do it as follows:
- Start with the basis of your old property
- Add any funds "contributed" when buying the the new property. This could be through cash you put down or through a bigger mortgage
This is a simplified example and if boot is involved the calculations get a little more complicated. There are a couple of things to note here as well. One, the basis you can depreciate after a 1031 exchange is lower than if you bought the property outright. Two, the basis you brought over from the old rental will continue to depreciate on the schedule it was on when you sold it. In other words, if you had been depreciating it for 10 years, you will have 17.5 years remaining on which to depreciate it. Any basis you contributed would have a 27.5 depreciation period.
Tax Deferred is Not the Same as Tax Free
When you eventually sell the property, if you do, the taxes will come due. But a dollar in taxes today "costs" more than a dollar in taxes 10 years from now due to the time value of money. And...there is a way to transfer the asset tax free. If you own the property until your death the basis will step up to the fair market value as of the date of death and all the gains will go away as will the tax bill that comes with them. I've heard this called "swap 'til you drop".
1031 Exchanges are Complicated
While not an issue confined to military officers, you'll want to consult with a Financial Planner or Tax Advisor that is familiar with tax issues related to military service before executing a 1031 exchange. It may be that the 1031 exchange is not the best option for you, even if you're going to buy a new rental based on the special tax provision concerning qualifying a property as a primary residence for those who moved due to PCS orders (see link to article below). Or it might be. That is why working with a professional can be well worth the time...and money.
If you found this article useful, you might enjoy these blog posts.