One strategy, for current investors and those considering future investment strategies, is the Internal Revenue Code Section 1031, commonly referred to as a 1031 Exchange. Used properly, this tax code allows a property owner or investor the opportunity to exchange property; deferring capital gain taxes, compounding wealth and building leverage.
To understand the powerful protection a 1031 Exchange offers, consider the following example:
Upon selling a property an investor projects a $200,000 capital gain with a projected tax liability of approximately $70,000 in combined taxes for depreciation recapture, federal and state capital gain taxes. Only $130,000 remains to reinvest in another property.
Assuming a 25 percent down payment and a 75 percent loan-to-value ratio, the seller would only be able to purchase a $520,000 new property.
If the same investor elected instead to reinvest or “exchange” the entire $200,000 of equity, the buying power would allow a purchase of $800,000 in real estate, assuming the same down payment and loan-to-value ratios.
By completing an exchange, the investor in the above example avoids capital gain taxes and increases the return on investment while building wealth.
When Albert Einstein was asked, “What is the most powerful force in the universe?” His reply was, “Compound interest.”
Piggy-backing on this powerful principle many investors have developed exchange strategies that have enabled them to vastly expand their net worth over a 10- to 20-year time frame. Exchanges encourage positive wealth building because there are no restrictions on the number of exchanges a taxpayer can complete.
Further, this strategy can be used during the taxpayer’s entire lifetime. Some investors eventually sell property purchased through an exchange and pay the tax. However, it is very common to never cash out and carry investments into the taxpayer’s estate. At that point, the estate receives a stepped-up valuation and the tax consequence goes away.
To qualify for an exchange, first and foremost, the seller must reinvest the proceeds of a sale or exchange into ownership of a like-kind property. These are defined as any other real property within the United States or its possessions if those properties are held for productive use in trade or business or for investment purposes. Examples of 1031 like-kind exchange properties include apartments, commercial, condos, duplexes, raw land and rental homes.
Secondly, within 45 days of selling the property, suitable replacement property, or properties, must be identified. The replacement property must be received by the taxpayer within the “exchange period,” which ends within the earlier of 180 days after the date on which the taxpayer transfers the property relinquished, or the due date for the taxpayer tax return for the taxable year in which the transfer of the relinquished property occurs. The transfer must also satisfy the three property rule, 200 percent rule and 95 percent rule.
In simple terms, any three properties may be identified as possible replacements. Any number of properties may be identified provided the combined value of those properties does not exceed 200 percent of the value of the relinquished property. Further, as long as you end up purchasing at least 95 percent of the aggregate value of all properties identified, any number of properties may be exchanged.
Another vital ingredient to qualify as a 1031 Exchange is the use of a qualified intermediary or entity that can legally create the exchange and prepare the legal documents.
The concept of deferring taxes and compounding wealth has tremendous appeal. If establishing a 1031 Exchange is a good option for you, then seek the expertise and guidance of your trusted, expert team of a financial adviser, accountant and Realtor.