When you work for a salary, or when you receive interest on a savings account, income from rentals, and so forth, that income is called ordinary income for tax purposes and is taxed at the standard rates. However, when you buy rental property (or other investments) and later sell, the profit or loss is treated not as ordinary income, but as a capital gain or loss. You are limited in the amount of capital loss you can deduct each year. If you have a loss greater than that maximum, the difference can be carried over to future years.

When you report a capital gain, the net gain is taxed at a different rate than ordinary income. The rate may also vary based on how long you owned the asset. The rules for treatment of capital gains have been altered many times by Congress, and probably will be changed again in the future. The amount of gain is calculated starting with the adjusted basis of the property. This is the original cost, plus closing costs paid at the time of purchase, plus capital improvements, and minus all depreciation claimed.

The actual capital gain or loss is the difference between the adjusted sales price (sales price plus closing costs) and the adjusted basis. If the adjusted sales price is higher, there is a capital gain; if adjusted basis is higher, there is a capital loss.

The year-to-year benefits of owning real estate are very attractive. These benefits, by themselves, often spell the difference between negative and positive cash flow. Even more attractive is the fact that, with proper planning, you can defer capital gains taxes¡ªin some cases indefinitely. All you need to do is replace one investment property with another of equal or greater value.

This rule applies to all real estate held for investment, whether residential or nonresidential. A deferred gain simply means that the profit, while subject to tax, is not recognized until a future period. You will eventually pay a lax on the profit, but for the immediate future, all of your profits can be turned around and invested in more property.

This applies only to investment property. For your own home, the rules are easier to follow. You are not taxed on any of the profit you realize from selling your home, up to a maximum of $500,000 (per married couple) or $250,000 (for a single person). This applies to only your primary residence, which is a home you must have lived in for at least two out of the last five years. You can escape tax on gains on your primary residence as many times as you like, with one important restriction: You can claim such an exclusion no more often than every two years.

If you acquire rental property and use it that way for several years, eventually moving to that house and making it your primary residence, you could sell at a profit and escape tax on most of that profit. You will have to declare as profit the amount of depreciation claimed while the property was rented out. 

The rules for deferring gains on rental properties are quite different. As a general rule, if you sell a rental property and make a profit, you are subject to capital gains. (Remember, "profit" is defined as your adjusted sale price minus adjusted basis, which includes adding back any depreciation claimed.) However, special rules apply allowing you to defer gains if you meet certain requirements.

Deferral for investment property is done by a like-kind exchange. That means that when you sell investment real estate, you need lo buy new investment real estate in order to fall under this rule. So, you can replace residential with commercial, or industrial with residential¡ªas long as it's still investment real estate.

Section 1031 of the Internal Revenue Code contains the rules for this kind of transaction. Because of the section in which these rules are found, like-kind exchanges often are called 1031 exchanges. Three special conditions need to be met for you to qualify for the deferral of gain under code section 1031:

1. You usually have to work through an intermediary. You need to set up the exchange transaction through an intermediary, often called a facilitator. This individual zannot be a relative or business partner, or your real estate agent, attorney, or employee. In other words, the facilitator has to be able to act as a neutral third party. The intermediary collects and pays funds much like an escrow agent or attorney in a real estate deal, primarily to ensure strict following of the rule that, in a 1031 exchange, You are not allowed to exercise control over the funds involved. The money has to roll from one property to another vithout your taking control of it, even for a moment.

2. you have to identify your new property within 45 days after the close of the sale of the old property. Identifying a property means finding a property that is for sale, and naming it as the "identified" property. The actual rules denning this process are quite complex. The intermediary you select to facilitate the 1031 exchange should be qualified and should understand the rules, so that you will be ensured of compliance. As pointless as these rules might seem, they must be followed or the deferral will not be allowed.

3. You have to dose the sale on the new property within 180 days from the close of your old property. The actual closing on the new property has to occur within 180 days from the closing of the old property¡ªno exceptions. If you miss this deadline, you lose the opportunity to qualify under section 1031, and that means you're liable for capital gains tax on the profits. In addition, you will still have to pay the facilitator for going through die steps up until this point.

 

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