The sale of a rental property is a taxable event

I sold a rental property this year, and bought another one of less value. Can I deduct the amount I paid in cash for the new property from the profits of the old one?

-- JB

No. Unless you do an Internal Revenue Code 1031 tax-free exchange, each property stands alone for tax purposes.

New rental property

You'll report the new property's cost and current year's depreciation on Internal Revenue Service Form 4562 Depreciation and Amortization. There will be no capital gains or losses until you dispose of the property.

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Old rental property

The sale of the rental property is a taxable event, and it gets reported on IRS Form 4797 Sales of Business Property. The sale will trigger a capital gains tax on the profit you made.

If you are being paid in installments because you're holding the mortgage, you don't have to pay capital gains tax on the entire gain this year. However, a portion of the principal you receive each month will be taxed as a gain. (And all the interest you receive is taxed.)

Here's how it works: Compute a gross profit percentage by dividing the gross profit by the contract price. Then calculate this percentage of the principal payments you receive each year, which gives you your capital gains for the year in dollars. You will use IRS Form 6252 Installment Sale Income to compute the percentage and the capital gains each year until the mortgage is paid off.

1031 tax-free exchange

The 1031 tax-free exchange lets you defer paying tax on some or all of the gain on your old rental property. The rules are very precise and complex. The Diva does not recommend doing this without professional guidance. Some of the basic requirements that will allow the transaction to qualify as a tax-free exchange are:

Both pieces of property must be for productive use in a trade or business or for investment.
All real property in the exchange must be located in the United States.
Must be "like-kind." Nearly all real estate for real estate exchanges qualify as "like-kind." The exchanged parcels do not have to be of equal value. If the exchange includes "like-kind" property plus cash, taxes on the cash portion of any gain cannot be deferred.
No money may cross your palm in making the exchange. If cash is involved, it has to be put in a qualified escrow account or go through a qualified intermediary -- usually the attorney handling the deal. It will be disbursed to the appropriate party after the exchange is completed.
After transferring your property to the new owner, the replacement property must be identified within 45 days and received within 180 days (or by the due date of your 1999 tax return, if that's sooner).

Make sure the professionals you use have experience working on 1031 tax-free exchanges. The rules are so complex that if they don't know them the accountant and attorney can spend so many billable hours studying that their fees wipe out any tax savings you would realize.