Capital Gains and 1031 Exchanges
By Michael Repka, LL.M. (Taxation)
DeLeon CEO/General Counsel
“In this world nothing can be said to be certain, except death and taxes.” – Benjamin Franklin
Though cheating death is a fool’s game, strategically and legally avoiding taxes is a game for winners. While most Silicon Valley sellers inevitably accept the large tax bills they will pay when they choose to sell, a savvy seller, coupled with a real estate broker willing and able to give competent tax advice, can avoid this fate.
There are great tax deductions, or deferral techniques, the federal government allows. Namely, these are the Section 121 $500,000 capital gains exclusion that married homeowners receive for their primary residence ($250,000 if single), the 1031 tax-deferred exchange for investment property, and the installment sale treatment under IRC Section 453.
Having traveled the world as real estate nerds, Ken DeLeon and I have researched the tax structures and incentives of other countries and found that no country provides as many tax subsidies for homeownership as America. Yet few people fully understand and utilize the two major tax exemptions for U.S. homeownership, and even fewer know these two benefits can be combined to fully avoid capital gains.
As you likely know, the first $500,000 in capital gains profit that a married couple has on a primary residence is exempt from any California or federal taxes. While this is exceptional and eliminates all tax concerns in almost all states, this exemption can be a drop in the bucket in prime Silicon Valley neighborhoods. This may initially prevent some owners from selling, but all current-year capital gains can be eliminated by combining this exemption with the strategic use of the 1031 tax-deferred exchange.
The 1031 tax-deferred exchange is a way for owners to sell their investment property, purchase another of equal or higher value, and then defer paying any capital gains. The concept is that, since the owners never actualized the gain, they just transferred their gains into another investment. Therefore, they should not have to pay capital gains on that new purchase. There can be a series of exchanges, and upon one’s demise these properties will be reassessed at market value and your heirs can then sell them without paying any capital gains.
While most people likely know of the primary home exemption and perhaps may have heard of the tax-deferred exchange, few sellers know these two great tax advantages can be combined to avoid paying any capital gains tax. Avoiding capital gains on your home may save you hundreds of thousands—perhaps even millions—and may make selling your home more attractive than you realized.
To be eligible for your primary home exemption, you must live in your home for two of the last five years. This means you can rent your home for up to three years and still get the $500,000 exemption. Once you rent your home for a year or more, it then becomes an investment property and thus eligible for the tax-deferred exchange. This means there is a window of time when your home is both your primary residence as well as an investment property. Thus, if you sell during that window, you can take $500,000 from your sales proceeds, invest the rest back into an investment property, and not pay a penny in capital gains!
To illustrate the savings, let’s say a couple of Atherton or North Palo Alto residents bought a home for $100,000 thirty years ago that is now worth $5 million. If this couple does the typical sale while living there or right after moving out, they have their $100,000 basis and their $500,000 exemption, but will pay capital gains on the remaining $4.4 million. With the top bracket of capital gains for California residents being 37.1 percent, these poor sellers will have to pay that percentage on their gain—a staggering $1,632,400—to the federal and state governments.
Alternatively, if they choose to strategically rent the home for a year before moving out, they can take this remaining $4.4 million and invest it in any real estate option in any state. For example, the sellers may want cash-flow, so they buy a large apartment complex with a live-in manager (so no work is required on their end) and get eight percent returns in areas with relatively high rental rates, such as Florida or Texas. Or, perhaps they seek less cash-flow and greater appreciation, and instead buy several duplexes in Mountain View and get good cash-flow while still tapping into Silicon Valley appreciation. The initial rental returns of local real estate is four percent (for example, a $5 million apartment complex should get the owner $200,000 per year for a four percent rate of return). This is quite favorable when you factor that rents have been going up by 10 percent a year and appreciation is projected for these multi-family properties.
Even with capital gains savings sometimes into the millions, most sellers do not fully utilize this savvy estate-planning tool. This is likely because most sellers, and even most real estate agents, are not fully aware of how to successfully navigate the requirements of the 1031 exchange and tax laws. However, if you speak to a real estate attorney or if your Realtor® is an attorney, you can be advised on how to strategically utilize this amazing tax exemption. Since my second law degree is in tax law, we can advise clients on all the nuances of the exchange and how not to have it disqualified. Additionally, we also assist our clients in facilitating smooth moves out of their homes and in identifying quality tenants.
Seeking to provide our clients with full-service, DeLeon Realty advises its clients on all legal and tax implications of any tax laws or ordinances. This is true whether it involves avoiding capital gains or carrying your low Proposition 13 tax basis with you if you are over 55 and meet other requirements. By properly utilizing these low tax exemptions, you can get closer to passing on your full $5.45 million tax-free to your heirs. In the end, it does not matter how much money you make or sell your home for; it is how much you net to enjoy and pass on to your heirs that matters.