A couple of years back, Moshe Chaim Schwartz bought an investment house for $150,000. The neighborhood had boomed as anticipated, and he now had an offer of $300,000 in hand. This was enough money for Moshe Chaim to buy a duplex in a new “up and coming” area—if not for taxes. His accountant explained that he’d owe about $37,500 in federal and state income taxes; in that case, he wouldn’t have the funds required to buy the new investment property.
What could he do to eliminate this tax bite?
Protecting Paper Gains
Real estate is a fantastic investment partially because of its unique ability to shelter much of its gains from taxes. Moshe Chaim can utilize a 1031 like-kind exchange to sell his property without paying taxes on the gains for years, maybe even permanently. This key strategy is based on the fact that gains from “paper” increase in value of investments aren’t taxed until they are cashed. While this is true for the growth of stocks and business values too, only 1031 exchanges enable investors to keep pushing off the “cash out” and triggering a taxable gain. And real estate is the primary beneficiary of this flexibility.
A Swap, Not a Sale
Here’s how it works. Moshe can proceed to sell his house. Although he’s now locked in $150,000 in gains, if he doesn’t take direct control of his money, it can be rolled over into the new duplex tax-free. At the closing, a “qualified intermediary,” such as the title company, directs the full $300,000 from the sale toward the purchase of the duplex. This maneuver is treated for tax purposes as an “exchange” of property, not a sale and subsequent purchase. The house and duplex are similar enough that they are treated as a swap. And if there’s no formal sale, there’s no tax owed!
Just Do It Again
This technical maneuver saves investors many thousands, even millions, in taxes. Theoretically, the taxes deferred via the exchange are still owed, but savvy investors can keep on trading with further exchanges. Say, for example, Moshe Chaim eventually gets a $600,000 offer for his duplex and wants to buy a small apartment building with the proceeds. With a typical sale, he’d owe about $112,500 in taxes. ($450,000 in gains over his original $150,000 investment x an estimated 25% rate= $112,000 owed). But by using a 1031 exchange, he’ll again pay no gains tax, deferring the even larger sum!
Keep On Swapping
Wealth obviously grows much faster if you don’t have to pay Uncle Sam every time you upgrade your portfolio. You may be wondering, though, what’s the end game? Eventually, don’t those taxes come due? Not necessarily. As the morbid line in the industry goes, you can “swap till you drop.” This involves using another massive investment tax loophole, the step-up in basis. When the owner of an investment dies, all the accrued taxes on paper gains are forgiven. While this rule does apply to stocks too, only a 1031 exchange allows for easy shifting of paper gains from asset to asset. Real estate’s combination of tax loopholes is unmatched.
But what if the real estate investor is ready to sell but doesn’t have an exchange property to buy? To make things even easier, 1031 rules allow for a delayed exchange. The details get pretty technical, but generally, as long as the property the seller intends to buy is identified and purchased in a timely fashion and no cash from the sale is removed from the hands of the qualified intermediary, it will still be deemed a tax-free exchange.
In this case, for Moshe Chaim to complete his exchange without having to pay tax on the sale, the full $600,000 proceeds of the duplex sale must go to the qualified intermediary. He then has 45 days to formally identify the apartment building as his exchange property. Finally, the closing on the purchase of the apartment building has to be completed within 180 days of the duplex sale (45 days to identify + 135 days to close = 180 days). Mission accomplished.
Out of the Tax Pan, Into the Fire
In our fictional case, the timing all works out perfectly. But it’s often much easier to sell at a high price than find another, more desirable property to swap into. Sometimes a sale occurs without any property being identified, and the 45-day window creates tremendous pressure to do a deal—any deal. Though buying a poor investment is usually worse than paying tax, the tumult of pursuing a 1031 exchange often leads investors to do just that.
Get Professional Help
In real life, 1031 exchanges are also more complex than the simplified examples provided here. What happens with outstanding mortgages? What if some partners prefer cash while others want to do an exchange? And there are specific rules guiding exchanging buildings for land and 1031 exchanges on vacation homes. Finally, primary homes have a totally different tax exemption. 1031 exchanges can do wonders for your wealth, but seek advice from a professional before utilizing this valuable but rigid strategy. Also, investors need to be aware that tax rules may change—especially now.