It’s called a 1031 exchange, or like-kind exchange, and it is an important strategy for building wealth through investment in real estate. It also confers a tremendous advantage for estate planning – one your heirs could benefit from in a big way.
Put simply, a 1031 exchange allows you to purchase property for investment or use in a business, then sell at a future date, deferring taxes due on any gains realized at the time of sale. If this sounds like a scam, be assured it is not. It is an IRS-blessed, legal means for deferring realized gain on the sale of investment or commercial real estate. (You cannot do a 1031 exchange with property you use as your primary residence.)
Here is an example to illustrate how this works. Pat Smithson purchased a rental duplex for $200,000 fifteen years ago. Pat wants to purchase an office building that she believes will give her a greater return on her investment, and will go up in value faster. The current market value of the duplex is $350,000. If Pat simply sells the duplex and uses the proceeds to help fund the purchase of the office building, she will have a $150,000 long-term capital gain and will have to pay federal income tax of 15% – 20% on that profit. That is at least $22,500 that just went bye-bye.
Instead, Pat could sell the duplex as part of a 1031 exchange. The proceeds from the sale would be held by an agent known as a qualified intermediary. Pat will have 45 days to identify the replacement property, ie, the office building, then 180 days to complete the purchase of that property, with the qualified intermediary assisting to complete the purchase with the $150,000 being held. Because it is possible that the replacement property she selected could get sold to someone else, Pat is allowed to select three possible replacement properties, and must close on one of those selected within the 180-day window.
The beauty is that instead of paying the $22,500 to the tax collector, and using the remaining $127,500 of her profit to purchase the office building, Pat was able to leverage the entire $150,000! That larger down payment meant she qualified for a better loan and could afford the more expensive office building.
Pat can do a 1031 exchange as often as she wants, maximizing her strategic investments, as long as she can demonstrate that her intent when she bought each property was to hold it for productive use in business trade, or for investment. By doing so, she is effectively using those tax-deferred dollars to build a substantial real estate investment portfolio. Those deferred gains, reinvested over and over, could mean the difference between some “nice rental income” in Pat’s retirement, versus significant wealth in her golden years.
Now, who out there doesn’t think that plan is solid gold?
But wait… there’s more. Pat’s investment properties, upon which she never paid any capital gains tax, continue to grow in value, and are worth $3.5 million at the time of her passing. If Pat’s properties get sold just prior to her death, she will pay hundreds of thousands of dollars to the IRS – money that she’d rather pass to her kids. If instead of selling, Pat holds the properties until she passes, her heirs will inherit the property at the current market value. (And with no estate tax due at all.) That means that if the heirs turn around and sell it at the current market value, they will have no profit to pay any taxes on. They will share a windfall of $3.5 million, tax-free.
And all Pat’s deferred taxes went poof – all gone.
That solid gold plan just turned into platinum!
If doing a 1031 exchange sounds complex and fraught with land mines, be assured that as long as you choose a qualified intermediary who really knows his stuff and has a long and excellent track record, it’s not hard at all. The IRS has very specific rules and requirements for how to legally do the exchange, but your intermediary will manage the process and keep you moving through the steps of the exchange in a timely manner. But you must know this: in order to benefit from a 1031, you must start the process before you close on the sale of the first property. If you’ve closed and received the proceeds, it is too late.
Another key to success with 1031 is working with a Realtor who can refer you to a top qualified intermediary, plus help you identify and close on the right properties.
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