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.

Most people I know got into that business by accident! After 18 plus years of dealing with landlords in their day-to-day business, assisting them in buying, selling and exchanging their properties. After many lengthy chats and informal surveys, I have come to the conclusion that most people got into this type of investment property by accident rather than on purpose.

Among the reasons most people finish there was they bought a new home and kept the old one. Some bought a house next door just so they could control who their neighbor would be, others helped a family member or a buddy with a loan and finished up getting the property instead of the loan repayment. There is also a considerable portion of this market who inherited their property and decided to continue in the business of their benefactor.

Another group of investors are those folks who attended a real estate seminar and actually implemented some of what they learned there or in the materials they purchased. Still others invested for the tax benefit and they are mostly large salary or high net worth individuals. Others got started by investing with partners or buddies and some even got started investing in REIT’s and limited partnerships.

And then there are the determined!

The folks with the plan! In my experience over the years, this is the smallest group in number but they’re the investment power in the rental property or multifamily properties.They bought, managed, bought some more, leveraged and exchanged into larger properties,or refinanced the properties they own and bought more. They did whatever it takes to grow their investment portfolio, because these folks recognized that real estate investments are the IDEAL investment for wealth accumulation and cash flow when done right.

Investors using real estate as a vehicle for retirement cash flow are typically the apartment landlord. In most cases their portfolio enjoys a more favored tax treatment while it remains outside the constraints normally associated with a retirement account. The rules,regulations and constraints like those found in IRA’s, 401(k)s 529′s and other tax favored facilities for investments and methods of wealth accumulation have limited flexibility for borrowing against and there are no withdrawal guidelines with respect to age for the real estate investor and his property.

Most all landlords, especially the determined are fully aware of the benefits outlined in IDEAL. which was adequately covered in a previous post here. The largest obstacle that all these folks have is getting good advise and direction from their paid professional advisers. Here I’m speaking of tax and legal advisers, and why it is necessary to only consult with specialists in that area or specialty.

The other area of concern is the type and caliber of real estate investment advisory or broker they use or choose to do business with. In order to successfully landlord, one needs to treat this business seriously, and that should begin with only working with specialized people in the multifamily property arena, and to use an old cliche in the business, “the day you buy, is the day you sell”. Sometimes the better option is to use the IRC Sec. 1031 or 1033 and defer or roll the Capital gain into the next building or real estate transaction.

Tomorrow we’ll expand on Sec. 1031 Tax Deferred Exchanges and and a brief look at the benefits to the investor starting at the beginning of the investment cycle.

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A Suburban Multifamily Community

Never! I don’t believe you’d come to that conclusion if read the articles in the financial press, but real estate has always been, and continues to be, the ideal investment for the average American. While it’s true, the best real estate most of us will ever own is the real estate we invested in at the beginning of our investment process. It’s just like the trees we plant, the best ones were planted a long time ago and if we use the same care in managing both the trees and the investments we’ll have the shade and shelter we need for retirement.

It’s interesting that most investors I speak with now are cautious about real estate investments, Why they’re cautious after nearly four years of declining prices at least here in Orange County, CA and almost record low interest rates for mortgages is a mystery to me.  In my humble opinion, this is precisely the time to make an investment even if it’s your first one.

Three years ago in our Orange an LA Counties market, most people would have told you that they wish they had purchased, and held on to more real estate over their lifetime. Now, is the best time to begin or add to your real estate portfolios especially if you’re  smart about the way you make your deals. Beginning or investors in the accumulation stage of their investment cycle can make great headway by using the IRC Sec 1031Tax Deferred Exchange to leverage their nest egg exponentially.

The one issue with real estate is the need to work at managing it yourself or give up some of your profit margin for a property manager. However, when all is said and done, this is no different than any of the other investments, except that in most of the others you do not have a choice. The investment is managed by a professional money manager or Wall Street type where the management fee is paid somewhere in the agreement. Nobody works for free or at least they didn’t in my 18 tears of financial markets.

The age old arguments against real estate as an investment is management and liquidity. The opinion or objection most offered by financial advisers about real estate is it’s lack of liquidity. This is a hollow argument. While it is true, one cannot execute a sell order an liquidate the real estate holdings immediately, real property priced right sells quickly and in most cases real estate can be borrowed against which are two ways to raise cash should the need arise.

The other advantage real estate has over the equity markets is you won’t be forced to sell at the wrong time by margin calls. You have more control over your own destiny and you can sell when the market will yield it’s highest return.  As in all markets,”Buy low, sell high” is sage advice, but when it comes to real estate. “Buy Now, hold for a long time, then use the IRC Sec. 1031 to defer your capital gains tax and roll all the profit into a larger deal is the real home run play.

More about IRC Sec 1031 later, but for now using this method, an investor will almost always yield fantastic overall investment results. Having spent a considerable amount of time (30 plus years) working in both market I’ve seen the good, the bad and the ugly in them both. Depending on where in your investment cycle, find an adviser you feel comfortable with and plan a strategy that will accomplish what you want.

If you’ve got a question or comment, we’d love to hear from you.