How to Delay Paying Taxes on your Real Estate Profits: the 1031 Exchange

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Aside from the implementation of your actual business strategy, there is nothing more important than being aware of, and utilizing, one of the greatest provisions of the Internal Revenue Code -- the 1031 exchange. The 1031 exchange, named, intuitively, after its provision in the Code itself, allows for the deferral of income tax on gains from property held for investment purposes by allowing those gains to be exchanged for similar (“like kind”) investment properties. I highlight “deferred” because it doesn’t allow an investor to avoid tax on the gains, but it allows tax on those gains to be deferred for as long as they are being held in a qualifying property. The great part about the 1031 exchange is that you can use it over and over again, as many times as you want. Therefore, you can defer taxes on your gains theoretically for your entire life. There’s also the potential, with some creative tax planning from your accountant, to never have to pay these deferred taxes, if you set it up in a way to pass it on to your children or even a charity (don’t quote me on this -- definitely check with your accountant on this one). Either way, the 1031 exchange is the single greatest gift the government has ever handed real estate investors. So, let’s see how it works:

Section 1031

Section 1031(a)(1) of the Internal Revenue Code states that “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” Essentially, from a real estate investor’s perspective, Section 1031 allows for the tax free exchange of one piece of investment property for another. As I mentioned earlier, it does not provide for tax avoidance, but instead tax deferral. This is because the “basis” in the property (defined as the property’s cost minus allowed or allowable depreciation) transfers to the next property, no matter that property’s cost. So, for example, you buy a property for $100,000, then renovate it and it’s now worth $200,000. Say that equals about a $50,000 profit. Now, instead of realizing that profit as income on that year’s tax return, you perform a 1031 exchange and utilize the proceeds to buy a $300,000 property. Here’s where the deferral comes into play. While you will not be recognized to have “made” $50,000 that year, the basis of the second property you acquired through a 1031 exchange will be reduced by the amount deferred (in this example, the $50,000 in profit that you would have otherwise been taxed on). Therefore, say you renovate and go to sell that next property, and you bought it for $300,000 and put $75,000 in it. Even though your actual cost basis in the property is $375,000, it would be classified as only $325,000 (because it would be reduced by the $50,000 deferred from the last sale). This means that your “profits” would look like they increased on the sale of the second property (because taxable profits are calculated as sale price minus basis -- so say you sold the second property for $400,000. Even though your actual profits on that property are $25,000 ($400,000 - $375,000), they would be classified as $75,000 because it would be calculated as $400,000 - $325,000). That’s ok though, because you would simply do another 1031 exchange and move on to the next property.

Section 1031 is actually relatively flexible in application, however it does have one formality. The proceeds of the sale of the first property cannot be physically received by the taxpayer (you). The section requires that a “qualified intermediary” be used. This individual or company receives the profits from the sale of the first property, and then holds on to them until the purchase of the next property. The section requires that your next property be identified within 45 days of the closing on the sale of your first property and actually closed upon (you take ownership) within 180 days of the closing on the sale of the first property. These calculations begin to run the day after you relinquish the property.

Although the very complicated list of situations and circumstances under which a transaction must fall in order to fit within the parameters of Section 1031 is very long, there are two main concerns to be aware of. Those are the type of the property you plan to sell and the type of property you plan to buy. In order to qualify under Section 1031, a property must be “held either for productive use in a trade or business or for investment.” Where this becomes sticky for real estate investors is regarding the classification of a property “held for investment” (does qualify) versus “held for sale” (does not qualify). A perfect example of  a property held for investment is any rental property, which is clearly held for investment. The problem with “held for sale,” however, is that it sounds a lot like a flip property. When you buy a property to renovate and flip, the intent from day one is to sell it (i.e. hold for sale). On it’s face, that then means it does not qualify for a 1031 exchange. That may not be true, however. This is where things go over my head. At this point, I pick up the phone and call my attorney and/or accountant. All I know is it’s a fine line, but is doable for flip properties. You just have to make sure to do it the right way.

The second thing to be aware of is the classification of the property you intend to acquire with the deferred profits from the sale of the first property. The section requires the property to be of “like kind.” This means that it also has to be held for trade or business or for investment purposes. The analysis is the same as determining whether your first property qualifies, but it’s important to note off the bat that each property has to be for trade, business or investment. That means that you can’t sell a flip property and then try to defer taxes on the profits from that sale by buying yourself a new home. The second property (your home) wouldn’t qualify, because you’re going to be living there, and not holding it for business or investment.

Conclusion

Although very complicated, Section 1031 is a massive boon to real estate investors everywhere. If you think about it purely from a profit standpoint, if you’re in a 30% tax bracket and you are able to avoid taxes on the profits from a sale, you just increased your short-term profits by 30%. That’s money you can now leverage and grow with future investments. Additionally, there is a very smart way of utilizing such exchanges to further your “big picture” investing strategy. If you diversify your real estate portfolio and follow a similar scheme as we’ve discussed here, you can use your flip profits to purchase rental properties, and by doing so via a 1031 exchange, acquire roughly 30% more income generating properties (because you’re re-investing money that you would have otherwise paid to the IRS), and it doesn’t take a rocket scientist (or a Federal Reserve Chairman) to realize how beneficial that can be over the long run. 

Finally, let me close with a disclaimer. I am neither an attorney nor an accountant. The information provided above is simply boozwatt.com’s continuing attempt to educate our fellow real estate investors for free, for the good of the community in these tough market times. If you ask any successful real estate investor, they’ll tell you that 1031 exchanges are an absolute must. When I first got in this business, I was having a discussion with a friend of mine involved in real estate in a different capacity. When we broached the topic of the $76,000 in profits I was about to make off my very first flip, she asked about how I was planning to “exchange” the property. When I looked at her like a deer in headlights, she responded, “don’t even talk to me about real estate anymore if you didn’t look into a 1031 exchange,” and ended the conversation. I thought it was harsh at the time, but she made her point. Once I looked into it, and set one up through an attorney, I couldn’t believe I might have done it otherwise. In fact, I still haven’t paid the roughly $22,000 in taxes I would have owed from that very first property years ago -- I’ve been rolling it through my properties ever since. GOOD LUCK!

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This page contains a single entry by the boozwatt team published on October 24, 2007 8:29 PM.

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