If you work in real estate, you probably deal a lot in finances. While nearly every American has to worry about paying taxes at the end of the year, those who deal in large or numerous amounts of money have a lot more to worry about than the average taxpayer in terms of complicated forms, deductions and payments.
That’s why the goal should always be to try to make your tax life as easy as possible. Whether this means having an amazing document resource system or the actual methods involved with your business operations, that’s up to you.
One method of tax deferral that we recommend to our real estate investor clients is a 1031 exchange. This method allows for a real estate investor to sell one property and reinvest that money into a new property, deferring all capital gain taxes. This works for you in two ways: 1) you’re saving on your taxes and 2) you’re making more money.
This comes from the IRC Section 1031, what the exchange is named for, and the (a)(1) tax code portion states directly:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business of for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business of for investment.”
This can save you a lot of time and money when it comes to filing your taxes in a big way. It’s easy to see just how beneficial this is when you put the idea in more laymen’s terms. The IRS is essentially banking on the fact that you don’t want to pay taxes now, so they’re giving you another option: defer your investment elsewhere, likely into a bigger property that counts as “like-kind,” and you’ll pay the taxes for the property you eventually end up with.
The loophole here is that you can do this over and over again, effectively growing wealth based on the actual money made from within the property while you move from property to property.
This means you’re using government funds as a sort of boost to your investment strategies since technically, without using a 1031 exchange, those taxes would have to go to the government. Instead, you get to keep the money as long as you invest it elsewhere, and the term “like-kind” can be pretty vague at times – essentially any other form of investment property is included in this umbrella. This in turn means you can invest in a variety of properties as long as they are found to fall under this blanket of “like-kind,” allowing for a more diverse real estate portfolio that was created with low risk.
Another rule to be aware of is that the second investment property, aka the property you are exchanging for, must be of either equal or greater value. This can actually be spread out between properties as well, so if you sell one property for $1 million, you do have the option of buying two properties that are valued at $500,000 in order to make the tax break.
Also, be aware that once you have started the 1031 exchange, the IRS allows for a 45 day window in order to recognize the property you want to buy. This may not be the most convenient rule, as anyone who invests in real estate knows this is an extraordinarily small time frame, but the benefits are well worth it if you can pull this off. If you’re looking for a tip, start considering the 1031 exchange before you actually finalize the sale of your property – that’s when your 45 day window truly begins.
So if you want to avoid spending taxes on real estate investment properties and simultaneously expand your resume or diversify your wealth, don’t put that profit in your bank account. Put it in a 1031 exchange.
If you are selling real estate and would like to discuss tax planning on any profits realized, please send me a note at firstname.lastname@example.org and I would be happy to discuss with you!