Utilize a 1031 Tax Deferred Exchange of Real Property
Often investors do not realize taxation on a personal residence is far different than taxation on an income or investment property. Under Internal Revenue Code 121, homeowners are allowed to exclude up to $250,000 of capital gains if single, $500,000 if married, upon the sale of a principle residence provided they have owned and occupied it two of the previous five years.
If an investor sells property they pay tax. Taxes are paid on capital gain, not equity or profit. However, property that qualifies for preferential treatment under Internal Revenue Code 1031 is treated quite differently. “No gain or loss shall be recognized if property held for productive use in a trade or business or for investment purposes is exchanged solely for property of a “like-kind.”
The benefits of exchanging include using leverage to maximize your investment dollars to property diversification to allow you the widest range of investment freedom. 1031 Tax Deferral can range anywhere from a simple swap of two properties to a complex, multi-leg, multi-property transaction involving a delayed, reverse or construction exchange. The investment strategy and the nature of the transaction will decide which exchange best suits your needs. Imagine selling rental property or land, acquiring new real estate of any type and not paying one dime in capital gain taxes. Thousands of investors are profiting every day simply by using the tax deferred sale IRC 1031!
Investors often mistakenly believe they must acquire property like their relinquished property. They are surprised to learn a wide variety of properties can be considered “like-kind.” “Like-kind” does not refer to the nature, character or type of property. Instead, it addresses the intended use of the property. Provided the property is initially acquired and held for either business or investment purposes, it can qualify as a suitable replacement property under IRC Section 1031. For example, any of the following can be considered “like-kind” property exchanges: a duplex for a fourplex, bare land for improved property, a rental house for a retail center or an apartment building for an office building. Investors do not have to exchange for exactly the same type of property as relinquished.
The tax code also lists items that are not considered “like-kind”. These include:
Stock in trade or other property held primarily for sale; stocks, bonds, or notes; other securities or evidences or indebtedness; interests in a partnership; Certificates of trusts or beneficial interest.
In addition, the Code was amended in 1989 rendering property outside the United States non “like-kind”.
Benefits of Exchanging
- Cash flow
- Management Reduction
Prior to 1979, trading properties was at best complicated. Completing a tax deferred exchange meant properties had to be “swapped” simultaneously. Unfortunately, this made exchanging cumbersome and risky, if not impossible. The 1979 Starker decision in the U.S. Court of Appeals enabled the non-simultaneous or “delayed” exchange to qualify for tax deferral. This gave investors the time necessary to find desirable replacement property by using an Intermediary. Treasury Regulations effective June 10, 1991 validated the delayed exchange and simplified the exchange process. By providing specific guidelines, these Regulations were welcomed by real estate investors who were previously uncertain of the viability of 1031 transactions.
Many investors have held property for years because a sale translated into paying taxes of up to 40% of their capital gain. Typically, as an investor’s needs change over the years, the type of investment property they want changes. Relocation, estate building, retirement, desire to increase cash flow, to reduce management responsibilities, all affect the type of property investors want to own. Under IRC Section 1031, investors now have the alternative of moving their investments (and equities) into more desirable or profitable properties. “The true power of exchanging is the ability to meet investment objectives without losing equity to taxation.”
“Every dollar saved will allow an investor to purchase 4-5 times as much real estate…” This is possible through leverage. Leverage is a method of acquiring real estate worth many times the value of the initial investment. Tax deferment increases leverage. To understand the power of leverage, consider that ten percent appreciation is converted to a 50% profit with a 20% down payment. The following example shows the value of leverage by illustrating the benefit of exchanging versus selling.
$200,000 x 40% = $80,000
If the investor sold property with a gain of $200,000, they would pay taxes of $80,000 and have only $120,000 left to reinvest. On the other hand, the investor who exchanges pays no capital gains tax, leaving the entire $200,000 to reinvest.
|Tax Owed||-80,000||Tax Owed||-0-|
|Cash to Reinvest||$120,000||Cash to Reinvest||$200,000|
If each investor purchases a building with a 20% down payment, using leverage, each could buy a property worth:
Sale Value $600,000
Exchange Value $1,000,000
In a single transaction, the investor who exchanged has $400,000 more property than the investor who sold property.