Tax Benefits of IRC Sec. 1031 Tax Deferred Exchanges in Real Estate
Lifetime Exchange Benefits
Here’s the biggest advantage of doing a 1031 exchange? By deferring tax, you have more money in hand to invest in another property. In effect, you receive an interest free loan from the Government, in the amount you would have paid in taxes. A wonderful estate builder indeed! In most cases the tax bite on the profits of a real estate deal fall between 30% to 35% and by doing an exchange the investor get to roll all the profits into the next deal. Consider what a benefit that is over a lifetime of investing.
Despite this generous benefit some folks elect to sell and pay the taxes. This is often done out of ignorance on behalf of the investor of the broker the used to sell the property. Another reason could be the seller decided to finance the deal for the buyer. Depending on what side of the deal you’re on with this seller financing there are advantages. However, the tax still has to be paid but the question now is, when?
Before you make a decision one way or the other, it would be prudent to examine the effect of your decision give the choices. In an 1031 Tax deferred exchange you can defer some or all of the taxes. You don’t have to do all or nothing! In a sale where the seller finances the deal, some taxes are paid at the time of sale and the balance are paid as the seller receives them with some exceptions. In an outright sale or “cash out” there’s an assortment of taxes due especially here in Orange & LA Counties. Here’s a list without percentages as they can change depending on your situation, Federal Capital Gains Tax, State of California Income Tax (or your state if the have tax), Federal Depreciation Recapture Tax. There’s also Property Transfer Tax on the entire sale amount even in exchanges. If someone tells you to pay the tax, it’s only 15%… Run! Find a new adviser.
Some folks confuse “tax -deferred” with “tax free”. They are quite different and you don’t want to discover that difference when you’re across the desk from the IRS auditor. Here’s the difference: In a 1031 exchange, you defer paying the capital gains taxes on your relinquished property. Its tax basis is carried over to the replacement property. When you finally sell the replacement property, without doing an exchange, you will pay the tax at that time. However, you may repeat this deferral process over and over again, from property to property over a period of years and under current law your immediate family can inherit the property with a stepped up basis. In other words, the capital gains tax is forgiven. Not Bad!
It’s refreshing to know that there is some break from the IRS in pursuit of capital gains tax.
As you might imagine, there are some rules and regulations to adhere to in a IRC Sec 1031 Tax Deferred Exchange. While the tax deferred exchange has been around since 1921, there have been some modifications in the rules. For this reason, it is very important to use the services of professionals who are familiar with these types of transactions. A mistake here could be very expensive and as everyone’s situation is different a consultation with an expert and some research of your options is a really good use of your resources.
Now we have the tax situation established we can examine the benefits of investing in multifamily properties or apartment rentals, and get down to most efficient way to manage them for fun, profit and devise an exit strategy that will work best for you.
