Once you buy your first investment property, you have taken the first step in increasing your real estate wealth. The next step will be doing a 1031 exchange and trading that property for something with grander possibilities and revenue streams.
Suppose you purchased a gnarly little triplex in Dogtown in the early ‘90s. These days, the property is valued in the $1 million range, but thanks to rent control, you’re bringing in about $40,000 per year in revenues. As authorized by Internal Revenue Code 1031, you can exchange that property for something more desirable — say a 12-unit property bringing in $216,000 per year in revenues.
Internal Revenue Code 1031 has allowed tax-deferred exchanges of investment and business properties since 1921. To qualify for tax-deferral when selling a property, an individual is required to trade an income generating property used for investment or business for a “like kind” property (or properties) equal to or greater than the equity of the one they are selling.
A qualified tax-deferred trade up is viewed, tax wise, as one continuous investment. So, if you exchange your property, you avoid paying taxes.
There is no limit to the number of times or the frequency you can use IRC 1031 to escalate your real estate wealth without paying capital gains taxes. Buy a fixer-upper on Tuesday, sell it Thursday, by a bigger fixer-upper next Tuesday. As long as it’s an investment property and not a primary residence, you’re good to go.
Noted real estate columnist Bob Bruss cites at least 10 reasons for exchanging real estate:
1. Pyramid your investment equity without tax erosion of your sale profit.
2. Minimize or eliminate the need for new mortgage financing on the property acquired.
3. Get rid of an undesirable property that is difficult to sell and acquire a better property.
4. Increase the investor’s depreciable basis.
5. Acquire a property which better meets the investor’s needs, such as more cash flow or easier management.
6. Partially defer profit tax by trading down to a smaller property that suits the owner’s needs.
7. Avoidance of depreciation recapture tax when selling a property.
8. Refinance either before or after the trade to take out tax-free cash.
9. Accept an unexpected purchase offer to sell a currently-owned property without owing tax.
10. Completely avoid capital gains tax by still owning the last property in a chain of tax-deferred trades when you die.
Commonly known as a Starker Exchange, Internal Revenue Code 1031(a)(3) allows an investor to sell his property, and have the sales proceeds held by a qualified third party, while he purchases his replacement property or properties.
IRS time limits give the investor 45 days to choose his next properties, and 180 days to complete their tax-deferred transaction.
“If you don’t have everything lined up you can miss those deadlines,” notes Margaret McDonnell, president of 1031 Corp. “It sounds like a long time, especially the fact that you have 180 days to close on a new place, but it’s really very short.”
Another option is a reverse exchange. As of late 2000, IRS Revenue Procedure 2000-37 has allowed the replacement property to be acquired by the third-party accommodator and held until the old property is sold.
Death is the ultimate tax shelter. Any capital gain tax you would have owed if you sold your real property (and other assets) is forgiven upon your death, and your property heirs receive a new “stepped-up tax basis.”
For details, consult your accountant.
* Jodi Summers’ column Days on the Market runs every Wednesday in the Santa Monica Daily Press.