2 Mistakes Selling - 1031 Exchange & Long-Term Gains
Current and aspiring real estate investors know that real estate offers several tax advantages. From deducting depreciation to deducting interest, there are several tax advantages available to investors.
While real estate investors are aware of the tax advantages, an inexperienced investor may not be aware of the intricacies and how they play out in real-life. One wrong move and you can be on the hook for more than you expect, diminishing your returns and lessening the cash on hand to invest.
In this post, I’ll go over my first-hand experience with how not fully understanding the 1031 Exchange and long-term capital gains hurt my bottom line.
In May 2015, I bought an empty lot in Stockton, CA, a 12,000 square foot empty land parcel for $45K. 11 months later, I sold the land for $65K in April 2016.
While I’m glad to have generated $20K in profit or ~50% gain in such a short time, I later learned two tax laws that I should have kept in mind that would have helped retain more of my earnings:
Tax Law 1: 1031 Exchange. When selling the lot, I thought I would not have to pay any capital gains tax. I had heard the concept spoken on various podcasts and read about it in articles, so I thought I was free and clear to sell with no tax impact. The concept I was referring to is the 1031 exchange, yet I was very incorrect in the application of the law. The 1031 exchange is when an asset – typically real estate – is sold and the proceeds are then reinvested in a “like kind” asset. By conducting this exchange, the individual will not recognize any losses or gains as per Section 1031 of the Internal Revenue Code. Capital gains taxes are deferred until property is sold and not exchanged.
My misconceptions of the law were: first, taxes would be deferred, not simply eliminated and, second, the buyer must disclose this to the seller and a custodian (3rd party) must be utilized. I did neither of these and was thus subject to paying taxes on the transaction.
Tax Law 2: Short vs Long-Term Capital Gains: While I missed out on the opportunity to defer taxes, I also missed on the opportunity to pay less taxes. In the US, a long-term capital gain is when an asset is held for at least a year and it is sold for a profit. A long-term capital gain allows an investor to pay a lower tax rate vs an asset that is sold for a profit and held for less than a year. Since I held the property for only 11 months, I had to pay 22% on my gains, rather than the 15% if I held it for one more month.
If there is one lesson you can take away from my experience, it is to talk to a Certified Public Account (CPA) on all transactions, even if you believe you know the Tax Code. In my case, I was aware of the 1031 Exchange, but not knowing the details hurt me financially.
While it’s helpful to know the tax code, real estate investors must stay focused on real estate to be an expert and ensure projects go according to plan, in a similar way that a CPA is focused on tax law to stay focused on adhering to law and generating the best returns for his/her client. In many cases, any fees you pay to our CPA for advice is also tax deductible.
And while talking to your CPA on all transactions is costly and time consuming, think about the potential costly mistakes you may make otherwise. CPAs want to stay in the know of all your transactions, and not be caught off guard by any transactions you did not tell them about, which would make their job even more difficult when it’s time to file tax returns.
While things worked out in the end, there is no doubt returns could have been higher. Had I consulted a CPA, I would have at least held the property for one more month and not have to pay an additional 7% in taxes. While these mistakes were costly, they are mistakes I won’t repeat again and mistakes that you can easily avoid.
