The 1031 Exchange and Its Incredible Wealth-Building Power
Published on: Friday, December 18th, 2015
When used properly, the 1031 exchange deferred tax regulations of the IRS Tax code are one of the fastest ways a real estate investor can build and increase their wealth.
What is a 1031 exchange?
A 1031 exchange allows a property owner to sell a property for a gain and reinvest the total proceeds of the sale into another “like-kind” property while deferring the taxes on the gain from selling the original property to a future date. A 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties. By deferring the tax, you have more money available to invest in another property. In effect, you receive an interest-free loan from the federal government in the amount you would have paid in taxes. It is similar to investing in a 401K retirement plan at your job, where you can put your earnings in pre-tax and only pay taxes when you cash in those stocks at a point in the future, except in real estate you can keep exchanging and trading up deferring taxes much farther into the future.
What is a “like-kind” property that can be used in a 1031 exchange?
Qualifying properties must be held for investment or business. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment. Most real estate will be like-kind to other real estate.
To enjoy the tax benefits of a 1031 exchange, you must closely follow all the rules and regulations in the IRS Code. It is extremely important that you work with experts in structuring your 1031 exchange, because some of the rules can be quite complex. Our team has worked diligently to identify experts that can keep investors from making serious mistakes. These mistakes can lead to the entire transaction being disallowed and the government may come looking for the payment of all taxes, plus penalties!
A 1031 expert can guide you with a confident hand. With that said, it is important to understand the benefits of a 1031 exchange. A 1031 exchange allows you to compound your wealth, increase your income and defer costly taxes.
1031 Exchange Example:
Let’s say you bought land 10 years ago for $100,000 and recently you had someone offer you $500,000 for that same land, as values had greatly increased all around you. Right now you have land that brings in $0 income and costs you $5000 in property taxes each year to hold. If you sold that property for $500,000 and didn’t do a 1031 exchange, you would owe taxes on the $400,000 in gains on your property. Now, if you used a 1031 exchange, you could take the entire amount from the sale, $500,000, and invest it in a multifamily property worth up to $2,500,000 (at 80% leverage) that paid you 8% or more annually through the cash flow generated from the property after paying all expenses. So, instead of paying taxes on a $400,000 gain, you could buy a $2.5MM property producing a $40,000/year income, not including principal pay-down and appreciation. Best of all, that $40K in income can be entirely or almost entirely covered by depreciation, allowing you to take that income without paying income taxes on it (ask a member of our team how this works).
You can quickly see how one or two tax-deferred exchanges over your lifetime could greatly expand your wealth and increase your spendable income.
Our team has done several 1031 exchanges and can help you with the rules and regulations. If the 1031 example above has peaked your interest, or if you’re looking for a 1031 expert, contact us via phone or e-mail, and our investment group will get you up to speed.