What is a tax-deferred exchange?
In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.
Section 1031 of the Internal Revenue Code provides 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. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
What are the benefits of exchanging v. selling?
A Section 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.
Any gain from depreciation recapture is postponed.
You can acquire and dispose of properties to reallocate your investment portfolio without paying tax
on any gain.
Why would someone want to do a 1031 Exchange?
To defer capital gains tax on the sale of commercial, business, or investment property.
Is a 1031 Exchange a gimmick or loophole in the Internal Revenue Code?
No. Section 1031 has been a part of the Internal Revenue Code since the inception of the Code,during the 1920’s.
Is 1031 only for capital gains?
No. Section 1031 applies to capital gains taxes (15%), depreciation recapture (25%), and state income taxes (generally 8% to 9% where applicable). Long-term capital gains taxes apply to property held over 1 year – gains from property held less than a year are typically taxed as ordinary income.
How long must I hold my current property in order for it to qualify for a 1031 Exchange?
Property involved in a 1031 Exchange must be held for “investment or productive use in a trade or a business.”
When looking at “investment intent” the courts will often look to the period of time over which the property is held. That said, there is no specific holding period requirement for either the relinquished or replacement property.
Taxpayers who hold their relinquished property for two years satisfy the requisite intent for a 1031Exchange (or two tax reporting periods, since in an audit the IRS may look backwards and forwards two tax returns). A holding period of over a year has generally been accepted, but may be subject to review by the IRS. A much shorter holding period has been accepted, where a change in circumstances indicates that the taxpayer had intended to hold the property for a longer period. The IRS will look at ‘investment intent’ and will call a taxpayer quickly flipping property a ‘dealer’ vs. an ‘investor’.
Do I have to know what property I will be purchasing when I start the exchange? No. You have 45 days from the sale of your relinquished property to identify your potential replacement properties.
How many potential replacement properties may I identify?
3-property rule: You may identify up to 3 properties without regard to their value.
200% rule: You may identify more than 3 properties provided that their combined fair market value does not exceed 200% of value of the relinquished property.
95% rule: You may identify any number of properties, provided that you acquire 95% of the fair market value of those properties.
May I do a 1031 Exchange, and later move into the replacement property as my personal residence?
You cannot purchase the replacement property with the intent to move into it as a personal residence. If, however, you hold the replacement property for a sufficient time to establish the requisite intent for a 1031 Exchange, then you may move into the property and thus change the nature of the use of the property.
After moving into the property, a taxpayer may look to take the Section 121 exemption for personal residences. Under the recently enacted law, to gain the 121 exemption, the property must not have been the subject of a 1031 Exchange in the previous 5 years (that is, 5 years from the closing of the phase 2 acquisition).
Why should Real Estate be part of any Investing Portfolio?
Over the past two decades there has been a shift in the way that our society thinks about retirement planning. A generation ago workers could depend on a steady pension to fund their quality of life after retirement, supplemented by Social Security.
Today the situation is gradually changing. Social Security is in trouble and Fortune 500 companies regularly make headlines by defaulting on their pension obligation. The safety net that previous generations depended on is starting to look a bit frayed, and more responsibility is falling to the individual.
This is not necessarily a bad thing for those who are proactive about their retirement savings. But it does require us to make decisions that our parents didn't have to. Stocks? Bonds? Real Estate? Where should you put your money?
It all comes down to Volatility and Leverage. In your investment strategy you want high returns and low volatility (risk). Usually this involves a trade-off. Higher risk investments tend to have higher returns (small cap stocks and non-investment grade bonds, for example). Lower risk investments tend to have lower returns (government bonds, CD's).
One dollar invested in real estate in 1987 would be worth around three dollars now, a rate of appreciation of around 5.6 percent. This compares unfavorably with the 10% - 11% returns that the stock market has given.
This comparison, however, ignores risk and volatility. It's been a rocky ride for stocks, as most of us know. Compared with the ups and downs of the stock market, real estate has appreciated steadily.
This is an important distinction, because it means that prudent investors can use leverage to boost the returns that they make on real estate investments. Investors don't invest by plunking down 100% cash. They invest by financing their purchases, then using rent income to cover the cost of the mortgage.
Taking this into account, the Leveraged Real Estate Investment outperforms both the NASDAQ and S&P 500.
Stocks versus Real Estate
#1 Performance: Stocks Win
Based on performance and rate of return, stocks win. The long-term mean return of real estate is 3% a year while that of stocks is 9% - 10%. Now given the specific time period of 1978 - 2004, paper investments have trounced the return of hard real estate with the S&P yielding 13.4% while housing delivering an annualized return of around 9%.
#2 Leverage: Real Estate Wins
Though you can use leverage or “other people’s money” to make money in stocks as well (which you’d do by going on margin or buying options), it is easier and potentially more financially rewarding to do so via real estate. Leverage via real estate is also much more commonplace as homeowners strive and stretch to buy their homes with what they can afford. Doing so has made fortunes for countless households across the nation.
#3 Costs: Stocks Win
In a nutshell, stocks trade for a transaction cost of $10 or less these days, and funds charge 1% or lower of your investment account. Real estate transactions can run you 10% of your home’s sale price with fees covering appraisals, inspections, processing, title insurance, credit report checks, transfer tax, agent costs, moving costs and the like.
#4 Taxes: Real Estate Wins
Stocks have a long-term capital gain tax rate of 15%. You can also offset your stock gains by your losses. But check out real estate tax breaks: you can deduct mortgage interest and property taxes; you can claim the first $500,000 of profit from your home’s sale tax free, and there are also rental and commercial property tax breaks available such as deductions on maintenance and repair expenses on rentals, depreciation, property wear and tear. Note however that there are tax implications for unloading rental and commercial property.
#5 Transparency: A Draw
How well do you know your investment? How accessible, real and tangible are they to you? It appears that in the world of stocks and real estate, they each have their pros and cons. Ultimately, you’ll just have to trust the information available about that piece of property or that company’s offerings when you plunk out the money to make your purchases. Due diligence can tip the scales in your favor but doesn’t erase the risks inherent in any investment.
#6 Effort: Stocks Win
It’s clear that maintaining a stock market portfolio is far easier than running to and fro to your rental property making sure that repairs are being done. On top of that, with real estate you’ll have to deal with the human factor as well, where you’ll have to negotiate with tenants who may or may not give you a hard time.
Why invest in Real Estate?
With so many investment avenues available (and with Wall Street riding a multi-year bull market) it is a legitimate question. There are numerous places where you can invest your money with little or no involvement.
Why then, Real Estate? It depends on whether or not your investment goals are long term or short term.
Long Term
In the long term, historically Real Estate property has shown a consistent growth in value, even when some other investment choices were less stable. If there is an increase in value and you are paying down your mortgage balance, its pretty simple: You increase your equity in the property and add to your net worth. The nice thing about it, if you have purchased the property right and maintained it properly, your tenants, in effect, make your payments for you! In addition, there may be tax advantages available to you when you deal in a long term Real Estate Investment. Although there are definite limits to these potential advantages, they can be substantial. Consult a tax or legal professional to see how your situation would be affected.
Short Term
In the short term, Real Estate makes a great investment simply because the numbers are so large. It is not like buying a $200 watch and reselling it for $250. Yes, the return percentage will be high, but you still only made $50. With Real Estate, a decent rate of return can mean big profit dollars.
Take the following as an example. You buy a property in need of repairs for $38,000. Your total costs of rehabilitation, holding cost, and selling costs total $9,500. You sell the property for $58,000 and close on the sale 6 months after purchase.
Buy at: |
$38,000 |
Rehab/holding/selling costs: |
$9,500 |
Sell at: |
$58,000 |
Profit: |
$10,500 (22% of original $38,000 + %9,500 investment) |
Annual rate of return: |
44% (22% for 6 months = 44% annually) |
WHY LAND IS A WISE INVESTMENT?
LAND REQUIRES NO UPKEEP
You don't have to be there to tend an empty parcel. Unlike apartment buildings or commercial properties, you spend nothing in maintenance. You don't have to worry about sloppy tenants or unpaid rent. In fact, the land value keeps growing even if you NEVER see the property.
LAND NEVER WEARS OUT, NOR DEPRECIATES
Nothing can destroy the land and since land is a fixed commodity, its value MUST continue to rise as more people move into an area. Detroit can build more cars, Wall Street can float more stock issues, but there is only so much land and no more.
LAND IS THE ORIGINAL INFLATION FIGHTER
A recent article in U.S. NEWS AND WORLD REPORT states that land values rose at a rate three times as great as the increase in the general price level over the last ten years. So you pay off your land with dollars that are increasingly worth less. But your growth rate keeps you at least even-and in most cases, pushes you ahead of inflationary trends. You have REAL financial security.
LAND IS AN EXCELLENT TAX SHELTER
Property taxes and interest charges in most cases are tax deductible. Yet, at the same time, undeveloped property taxes are low enough so as not to be a real financial burden.
What is the right type of property to buy?
This question is probably the one asked most often by those wanting to invest in property. The short answer is that it all depends on what you’re aiming to achieve from your investment portfolio.
Before you can establish what the “right” property is for you, you will need to establish your investment goals. Ask yourself the following questions:
Do you need your property to give you positive cash flow?
What capital growth rate would you like to achieve?
Are you prepared to buy a property that needs some renovation or repairs?
After you have done this, put together a list of criteria for your properties. Some people will only look at properties that give them a positive cash flow; others only want to invest in residential property. Some people will only invest in units, while others see houses as a good investment. Some want to invest in their local area or city, while others will look in the country, interstate or even overseas to find the best deals.
In short, in our opinion, the “right” property is the one that will give you the best financial outcome in terms of cash flow and capital appreciation, regardless of the type of property or location.
What are some ways to achieve positive cash flow from property?
There are a number of ways to achieve positive cash flow from your property investments. They include:
1 Finding Properties that give you a rental return over your mortgage rate (usually more prevalent in regional areas although this depends on the loan amount and the cash you put into the deal. (See question above)
2 “Manufacturing” Income and/or Growth including renovating or rehabbing a property, development or re-development of land or houses, subdividing land, converting one property into multiple residences i.e. student accommodation, boarding house or units (these are always subject to authority approval, of course), strata titling of single title apartments or unit blocks, having land re-zoned (if possible), creating dual occupancy or medium density properties.
3. Wrapping
4. Lease Options
