I plan on selling wisconsin rental property in 2018. I do not own other real estate. How do I avoid paying capital gains next year?

[NancyG · Accepted solution]

Consider a IRS Section 1031 Like-kind Exchange.

What is IRS Form 8824: Like-Kind Exchange

Ordinarily, when you sell something for more than what you paid to get it, you have a capital gain; when you sell it for less than what you paid, you have a capital loss. Both can affect your taxes. But if you immediately buy a similar property to replace the one you sold, the tax code calls that a "like-kind exchange," and it lets you delay some or all of the tax effects. The Internal Revenue Service (IRS) uses Form 8824 for like-kind exchanges.

What happens in an exchange?

A like-kind exchange doesn't eliminate taxes; it just pushes them into the future. Say you paid $20,000 for your warehouse and sold it for $30,000 ($30,000 - $20,000 = $10,000 capital gain). Rather than have the $10,000 profit taxed as a capital gain, the like-kind exchange allows the gain to be "passed on" to the new warehouse.

The $10,000 gain will be factored into the tax calculation when you eventually sell the new warehouse -- unless you do another like-kind exchange, in which case the gain gets passed on to the next property you buy.

When completing the form, it’s important to keep the following in mind:

• Part I of Form 8824 is where you provide details about the old property and the new property 
• Part II of the form comes into play only when a like-kind exchange involves "related parties" -- members of a family or entities that you have a controlling interest in. 
• Part III is for reporting details about any gains or losses from the transactions that make up the exchange - this is how the IRS keeps track of your taxable gain or tax-deductible loss
• The form has a Part IV for use only by certain federal employees; it deals with conflict-of-interest rules

Allowable exchanges

Both individuals and businesses -- corporations, partnerships and sole proprietorships -- can carry out like-kind exchanges. However, the property involved must be used for business or investment. You could do a like-kind exchange on, say, boats used for a fishing business, but not for your family's sailboat.

Like-kind exchanges don't have to be exact replacements -- a warehouse for a warehouse, for example -- but they do have to be of the same "nature, character or class," the IRS says. Swapping a warehouse that includes land for vacant property or a factory with land would be a like-kind exchange, since all involve real property.

Exclusions and deadlines

By law, several kinds of property do not qualify for a like-kind exchange:

• Business inventory 
• Stocks, bonds and other securities 
• Ownership interest in a partnership business 
• Certificates of trust or an interest in a trust as a beneficiary 
• Rights to sue

Also, like-kind exchanges carry limits on how long you have to identify and acquire a replacement property:

• 45 days from the date you sell to identify potential replacement property and notify the seller of the replacement property or your intermediary
• 180 days after the sale to complete the acquisition of the replacement property

Failing to meet these deadlines may cause the sale of the property to be recognized in the current tax year.

[ajmac3242]

In my situation I have a rental property that we would like to sell and purchase a larger rental property. As of right now we stand to gain about $150k from the sale of our property. Obviously, we would like to avoid paying capital gains. Are you saying that in Wisconsin we must purchase another like (rental property on our case) investment property within 180 days to avoid paying gains? What happens if we don’t put all $150k down on the next property? We are in a unique situation where we purchased a property in Milwaukee for $50k (cash), put $50k into the property, and took out a loan for $100k. Now that home is worth $200k. I am assuming we pay gains on the purchase price not the original loan amount. 

[DavidS127]

No, you can't just sell your property for money and use the money to buy another similar property within 180 days, unless you use a "Qualified Intermediary".  You must either exchange your property directly for another property, or use a Qualified Intermediary for a "three-party exchange".  If you are considering a like-kind exchange, you will need a real estate agent who understands how to guide you through the process.

NancyG has given the essentials of the like-kind exchange in her response.  IRS Publication 544 Sales and Other Disposition of Assets covers the IRS rules for like-kind exchanges in detail.

The gain on the property you currently own is the difference between what you sell it for and your "adjusted basis" in the property.  That gain is then "split" between "recapture of depreciation you deducted (or should have deducted)" which is taxed at ordinary income rates; and "capital gain" taxed at the capital gain rates.

Your adjusted basis is typically "what you have in the property ($50K purchase + $50K invested = $100K)" minus  "the depreciation you deducted (or should have deducted)".  For the details on basis, click here for IRS Topic No. 703 Basis of Assets.

@ajmac3242