Timing the Market and Minimizing Taxes

Industry Observer with The Real Estate Solutions Guy

With property values back to highs that haven't been seen in several years, many owners are looking to sell their rental properties. However, many are also feeling the pain of depreciation deductions on their taxes. If you own rental property or non owner occupied property, you probably were excited about being able to get a tax deduction for depreciation of your property. In fact, even if you weren't excited about it, the IRS required you to depreciate certain items. Many investors try to accelerate their depreciation and get greater tax write offs. This works fine, provided the investor has an exit strategy that will minimize the depreciation recapture tax the IRS collects when you resell the property.

What do I mean by this? When you write off depreciation over the course of time, that amount can add up to several thousand dollars. However, when you sell the investment property, the IRS looks at the sale of your property as though you recouped all of the depreciation and thinks of that as income to you. As a result, the IRS taxes those "recaptured" dollars, typically at rates of 25%.

Can't Afford to sell Because of Taxes?

I keep hearing, "We can't afford to sell the property because of depreciation recapture". Unfortunately, sooner or later one has to pay the recapture tax, with one exception. When you die, your property passes on to your heirs without any of the taxes. If your intent is to leave real estate as an inheritance, this is a great plan. However, if you are looking to move your investment dollars to a more liquid position, then you are faced with how to reduce your depreciation recapture tax. This requires the expertise of a qualified CPA with experience in this area.

Avoiding Depreciation Recapture Tax - 1031 exchange

There are a couple solutions to this problem. The most common solution is to do a 1031 Exchange. In a 1031 Exchange you trade one investment property for another. From an IRS viewpoint, you are trading your basis, what you have invested in the property and your depreciation, from one property to another. This means that the depreciation that has been accumulating for years transfers to the new investment property without being subject to the recapture tax.

The challenge with 1031 exchanges is the timing and complex rules sellers face. In an Exchange the seller must identify and close on the replacement property within the timelines established by the IRS. The sellers may have had a replacement property previously lined up. However, after their due diligence, they decide against the new property and begin looking for another. It is not uncommon to find a seller desperate to find a new replacement property because their 1031 time period is running out.

How to extend your 1031 exchange time window

Consider what would happen if your buyer allowed you to have a prolonged escrow. What if the buyers were willing to wait, 90-120 days to close? Under an extended escrow, the seller could take their time doing their due diligence on new properties. Once they had completed their due diligence, they could start the closing process on their original property. This wouldn't probably work for a typical end user who intends to live in the home; but it might work for a rehabber or investor who is moving up.

Timing and Cash Flow

However, what if you don't want to give up the cash flow from your rental, but don't want to deal with being a landlord/owner any more?  And because home values are up, you want to sell now.  In another post I give the following example of how an installment sale may be a better alternative in some cases to a 1031.

Example: Sue has a property that she originally paid $100,000 for and is now worth $200,000. The property has been fully depreciated and is subject to $25,000 in depreciation recapture. In addition Sue also owes taxes on her capital gains. Sue wants to sell this year because property values are high and so is demand. However, Sue is in high tax bracket this year and would like to reduce her taxes. She wants to defer the income from the sale of her rental property to years where she's likely to be in a lower tax bracket.

The installment sale - An alternative to 1031 exchanges

With Installment Sales, you can sell your rental property over time and spread out your taxes. Note, I did not say eliminate them simply spread them out. The process works similar to selling your property with you carrying back a loan to the new buyer. The benefit is that the depreciation recapture and the capital gains taxes are spread out.

Example: I'll continue with the example above. Sue sells her rental property using an installment sale that spreads the purchase over 5 years. Sue has a promissory note and Deed of Trust that protects her in the event her buyer fails to make the payments. By spreading the sale of her home out over 5 years, Sue defers some of her capital gains to later years when she will be in a lower tax bracket. She also spreads the depreciation recapture out over 5 years, so that each year she only has to pay $5,000.

Talk to your CPA

We are not tax advisors or CPAs. Please make sure to talk to your CPA about these options if you are considering any of these concepts. The intricacies of tax law are too complex to discuss here in this short of time.

Comments (13)

Sybil Campbell
Fernandina Beach, FL
Referral Agent Amelia Island Florida

Welcome to Active Rain and congrats on your first blog post. This is a great place to meet and interact with some awesome professionals Robert Taylor.

May 15, 2017 06:19 PM
Robert Taylor

Thank you Sybil.  I'm looking forward to it.

May 15, 2017 07:26 PM
Les & Sarah Oswald
Realty One Group - Eastvale, CA
Broker, Realtor and Investor

Hello and welcome to ActiveRain.

Great post regarding 1031 and its benefits to investors.

You are going to be a huge asset to AR. Looking forward to reading your future posts.

May 15, 2017 06:43 PM
Robert Taylor

Thank you!  I'm excited to be here and looking to learn from everyone else's expertise too.

May 15, 2017 07:28 PM
Diana White-Pettis
Bennett Realty Solutions - Upper Marlboro, MD
GRI, CDPE, CNE, WHC Upper Marlboro Homes for Sale

Robert, welcome to ActiveRain. What a great first blog post on a topic that is of great concern to investors!  Very informative post!

May 15, 2017 07:46 PM
Bob Crane
Woodland Management Service / Woodland Real Estate, EXP - Stevens Point, WI
Forestland Experts! 715-204-9671

Thanks Robert, some advice that I could use as we are liquidating several properties this year.


May 15, 2017 10:31 PM
Robert Taylor

Thank you Bob.  Best wishes in your asset rearranging.  Make sure you keep as much as you can from Uncle Sam!

May 16, 2017 04:05 PM
Bob Crane
Woodland Management Service / Woodland Real Estate, EXP - Stevens Point, WI
Forestland Experts! 715-204-9671

Welcome to Active Rain, looking forward to reading many more of your posts, let me know if there is anything that I can do to help as you get started here.
All the best of success to you.

May 15, 2017 10:31 PM
Kat Palmiotti
406-270-3667, kat@thehousekat.com, Broker, eXp Realty - Kalispell, MT
Helping your Montana dreams take root

Welcome to ActiveRain! There haven't been too many posts about 1031 exchanges so this was a good topic for your first post!

May 16, 2017 03:27 AM
Robert Taylor

Thank you Kat.

May 16, 2017 04:06 PM
Barbara Todaro
RE/MAX Executive Realty - Retired - Franklin, MA
Previously Affiliated with The Todaro Team

Good morning, Robert Taylor thank you for sharing this information on how to rethink the tax obligation involved with selling an investment property.... 1031 exchange is a great solution....

May 16, 2017 05:26 AM
Robert Taylor

Thank your Barbara.  1031s are always a challenge and be more expensive than some of the alternatives.

May 16, 2017 04:07 PM
Barbara Todaro
RE/MAX Executive Realty - Retired - Franklin, MA
Previously Affiliated with The Todaro Team

and welcome to ActiveRain...it's a great way to learn, share, market and network....and I hope you enjoy it and benefit from all of it....

May 16, 2017 05:27 AM
Will Hamm
Hamm Homes - Aurora, CO
"Where There's a Will, There's a Way!"

Hello Robert Taylor and Welcome to the Rain where we all learn from each other and we all help each other.  Make it a great day!


May 16, 2017 06:50 AM
Robert Taylor

Thank you Will.  I'm hoping to learn a lot here too.

May 18, 2017 02:04 PM
George Souto
George Souto NMLS #65149 FHA, CHFA, VA Mortgages - Middletown, CT
Your Connecticut Mortgage Expert

Robert welcome to ActiveRain and congratulations on posting your first re-blog on this site.

May 16, 2017 03:46 PM
CA COASTAL ESTATES Lauren Selinsky Perez CRS
California Coastal Estates - Aliso Viejo, CA
"Your Real Estate Broker" #oclauren

Good info Robert!

Welcome to ActiveRain!

Following you now to see your blogs too.

Lauren Selinsky

May 16, 2017 10:15 PM
Robert Taylor

Thank you Lauren.  Appreciate the kudos.

May 18, 2017 02:05 PM
Gita Bantwal
RE/MAX Centre Realtors - Warwick, PA
REALTOR,ABR,CRS,SRES,GRI - Bucks County & Philadel

Welcome to active rain. Good luck in achieving your goals on active rain 

May 17, 2017 03:06 AM
Robert Taylor

Thank you Gita.

May 18, 2017 02:06 PM
Inna Ivchenko
Barcode Properties - Encino, CA
Realtor® • GRI • HAFA • PSC Calabasas CA


Welcome to the Active Rain community! 

It is a great place to learn new staff, make great connection, market yourself and your business,  and share things you passionate about. 

May 21, 2017 12:23 AM