Q. We are under contract to sell a house that has been a rental property for many years, and we’re looking at another property to use as a rental. Am I correct in thinking that we have only 45 days to close on a new rental property so we won’t have to pay capital gains? Will this keep us from needing a 1031 exchange? How would this work?
— Figuring it out
A. Here’s how it works.
If you are selling a property, intending to purchase a replacement like-kind property and you want to defer the tax consequences of a sale, then you probably want to engage in a tax-free exchange under Internal Revenue Code Section 1031. That’s where the term “1031 exchange” comes from.
The 45-day period after the sale refers to the time limit within which you must properly identify the replacement property, said Dave Ritter, chair of the tax practice at Brach Eichler in Roseland.
“You must then receive the replacement property within the earlier of 180 days after the date of the sale and the due date of your income tax return – including extensions if you extend – for the taxable year in which the sale closed,” Ritter said.
Generally, he said, a “qualified intermediary” is used to hold the money received in the sale.
“Your lawyer doing the sale transaction can not be the qualified intermediary under the IRS rules,” Ritter said. “If your lawyer receives the proceeds, you have technically violated the 1031 exchange rules.”
Ritter said you will also need certain exchange documentation, which may be prepared by the qualified intermediary or an attorney. The documentation is needed before you sell and should be put into place now.
“If the 1031 exchange is structured improperly, you may be deemed to have received the sale proceeds and the 1031 exchange will fail even if you buy the new rental property,” Ritter said. “There are various requirements and formalities other than the time periods which must be complied with properly. Professional advice is recommended.”
The federal capital gain tax rate for the sale of real estate is 20 percent with some portion taxable at 25 percent, Ritter said. There is also the New Jersey income tax. Many advisors will estimate a combined tax rate of 25 to 30 percent.
Good luck with the process.
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