Income Tax Strategies for Real Property (Part 1)

By William L. Exeter
President and Chief Executive Officer
Exeter 1031 Exchange Services, LLC

The sale of real property, whether it’s commercial or investment real estate or your primary residence or a vacation home, generally means that you will realize ordinary income, depreciation recapture and/or capital gain taxes.

Tax deferral and exclusion strategies can easily and effectively help you reposition your real estate portfolio in order to accomplish any number of investment objectives while deferring or excluding income taxes.

It is important for you to be familiar with the various tax deferral and tax exclusion strategies that are available to you. And, you should always consult with your legal, tax and financial advisors to ensure you select the most appropriate income tax strategy under your circumstances.

This article is the first in a series of articles on Income Tax Strategies for Real Property, and will introduce you to the various strategies available to you when selling real property. We will delve into greater detail on these strategies throughout this series.

Here is a brief summary of some of the Income Tax Strategies for Real Property:

1031 Exchange (Investment Property)
Section 1031 of the Internal Revenue Code allows you to exchange real or personal property that was held for rental or investment purposes, or that was used in your trade or business (relinquished property), for like-kind real or personal property that will be held for rental or investment purposes, or that will be used in your trade or business (replacement property), so that you can defer your capital gain and depreciation recapture income tax liabilities.

1033 Exchange (Involuntary Conversion)
Section 1033 of the Internal Revenue Code provides that real or personal property subject to an involuntary conversion, either from an Eminent Domain proceeding (condemnation by the government) or destruction by a natural disaster, such as an earthquake, hurricane or fire, can be exchanged on a tax-deferred basis for like-kind real or personal property that is similar or related in service or use.

1034 Exchange (Repealed in 1997)
Section 1034 of the Internal Revenue Code was repealed and replaced by Section 121 (see following) in 1997. The 1034 exchange allowed you to sell your primary residence and defer or roll over your capital gain by acquiring another primary residence of equal or greater value.

121 Exclusion (Primary Residence)
The Taxpayer Relief Act of 1997 repealed and replaced the tax deferral rollover provisions of Section 1034 with the tax-free exclusion provision under Section 121 of the Internal Revenue Code. Generally, you can sell your primary residence and exclude from gross income up to $250,000 in capital gains ($250,000 per taxpayer, $500,000 for a married couple). You must have owned and lived in the property as your primary residence for at least 24 of the last 60 months.

453 Installment Sale Treatment (Seller Carry Back Note)
Section 453 of the Internal Revenue Code allows you to sell real property and help your buyer finance the purchase of your property by carrying back an installment note (seller carry-back financing) while deferring the recognition and payment of your capital gain income tax liability until you receive principal payments. Depreciation recapture income tax liabilities can not be deferred under Section 453 and are due and payable in the year in which you sold your relinquished property. You can also accomplish this through a Deferred Sales Trust™.

721 Exchange (upREIT or 1031/721)
Section 721 of the Internal Revenue Code allows you to exchange investment real estate for an interest in a Real Estate Investment Trust (REIT). This is also referred to as an upREIT, or 1031/721 exchange.

The majority of investors will end up using the 1031 exchange to defer the payment of their capital gain and depreciation recapture taxes upon the sale of relinquished property and the subsequent acquisition of replacement property, so our series on Income Tax Strategies for Real Property will spend quite a bit of time discussing the 1031 exchange.