Ever wonder why real estate investors are so rich? Because they know two secrets: First, don’t pay for a property; exchange it with something you own already. Second, defer taxes on transactions, maybe forever.
These folks don’t part with a dollar when they acquire a property. They swap one property for a new one. Called a 1031 exchange, referring to its section of the tax code, this works only for business properties. Personal residences are ineligible for the 1031 treatment.
Typically, 1031s are used by major commercial real estate operators. Still, nobody is stopping you from adopting the strategy for smaller buildings.
Some planning is involved. Perhaps you want to exchange your vacation home for a property that is nearer to your residence. The most important step is to rent the vacation place out for at least 14 days annually for two years, back to back. To the IRS, you have a business asset.
That’s not all. Find the substitute property within 45 days of selling the previous real estate. Then purchase the new property within 180 days of the sale.
The beauty part: 1031 exchanges don’t require you to switch the same type of property. This means you can swap a block of apartments for a fast-food joint, or a machine shop for a bowling alley. The point is that these places all have a business or investment purpose.
Thankfully, the 2017 tax code overhaul didn’t rein in 1031s much. The one exception: The Tax Cuts and Jobs Act got rid of a provision in the law that let people swap assets like artwork and collectibles. Now, 1031s must be restricted to real estate.
About the taxes: Federal capital gains levies in 2019, for taxpayers who are married and filing jointly, are 15% for income of $78,751 to $488,850, and 20% above that.
When it comes to heirs, they inherit the property and are taxed on “stepped-up basis.” In other words, the real estate is valued at the market rate at the time of your demise. If you bought a small office building for $100,000 in 1990 and today it’s worth $300,000, your heirs aren’t penalized for the tripling of its value over time. If they sell it at once, they likely would owe zero.
The swap action does get complex in terms of accounting, however. You need to suss out how much of office building’s value is because of the building itself and how much is related to other elements, such as a new HVAC system.
But great fortunes have been built on real estate. And smaller ones, too. Keeping the tax man at bay is one crucial reason for such success.
Author: Larry Light
Source: Forbes: 2 Secrets To Playing Commercial Real Estate And Postponing Taxes