How to defer capital gains tax on long-term rental

Q: I have a summer cottage that I have had about 25 years and always rented it until two years ago when I used it during the summer for myself. I know if I sold it there would be big capital gains. I paid about $42,000 for the property and I might be able to sell it for $225,000.

If I sold it and bought another cottage/house for $250,000 and sold that in two years for $275,000, would the capital gains be less?

A: You've owned a piece of real estate for 25 years and rented it for most of that time. If you took advantage of the provisions of the tax code and treated the property as an investment property, for federal income tax purposes you probably took advantage and depreciated the cottage over those years. That depreciation gave you tax advantages over time, but now your tax basis for the cottage is close to zero.

That is to say, for income tax purposes, the IRS will treat the cottage as having little value, and when you sell it you'll have to pay taxes on the appreciation on its value. In addition, you'll have to pay taxes to repay the IRS for the tax benefits you received over the years for the depreciation you have taken.

If the cottage is still considered investment property by you and your use over the past two years has not converted the cottage from an investment use to a personal use, you can sell the cottage and defer paying any taxes on the sale of the cottage by using a 1031 tax-deferred exchange at the time you close.

You would close, but rather than getting any money at the closing, you deposit all the proceeds with a company that acts as an intermediary until you can find a replacement property.

There are many companies that act as a 1031 intermediary, but you need to make sure the company has been around for some time and actually has a mechanism in place to secure the funds it holds on your behalf and has a mechanism to protect those funds in case the company goes out of business.

Once you have closed, the 1031 exchange mechanism allows you 45 days to find and designate a replacement property and, in most cases, 180 days to close on the purchase of the replacement property. When you close on your replacement property, you will then use the funds held by the 1031 intermediary company, and you have deferred having to pay any taxes on the sale of the cottage.

Q: My mother deeded her property to me in 1998. The basis on her property was $40,000. Does the IRS track basis costs when a property has been deeded through several generations?

A: If the property had a value of $100,000 at the time you received it as a gift and you turned around and sold it, you would have to pay taxes on the difference.

In simple terms, when people talk about the term "basis," that term refers to the cost of the property adjusted for improvements and can be adjusted up or down for other reasons. If the property your mom gave you was vacant land when she bought it and it cost her $5,000, her basis at that time was $5,000. If she put a home on it at a cost of $35,000, the basis of her property would have been $40,000 even though the home might have caused the land and home to be worth much more than the $40,000.

While the IRS has various means to track property costs generally, I am not aware of any specific tracking mechanism it may have for specific properties. The greater issue for any person is making sure he or she files an accurate and complete tax return relating to the acquisition and sale of a property.

Prior to the elimination of the Rollover Replacement Rule -- the rule that allowed homeowners to sell a primary residence and not pay tax on the sale if they purchased a new home for a greater value within two years of the sale -- a homeowner filed a tax return with the sale of each residence and a computation of the basis for that residence. If a person bought and sold a primary residence and bought successive replacement residences, that person's tax return would show the basis for each successive home.

To that extent, the IRS would have records of the basis for a particular property sold and the carryover basis for a property purchased for that person.

If you were looking to determine the basis of a property your mom owned, you would look at the tax return filed for the year or years after the home was sold to see if she filed the required paperwork in connection with the sale of the home.

To get even more valuable advice from Ilyce, visit her Personal Finance and Real Estate Center.

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