It’s everyone’s greatest dream–get wealthier and reduce your taxes to boot. You probably think that the scenario is impossible–just can’t be done. BUT it is not only possible. It’s done regularly. How?, you ask. Well, it’s fairly simple!
The way you increase your assets in tis case is to buy and hold real estate. It really makes no different what type of real estate–a house, warehouse, office building or condo. All types are suitable for this method. The slightly more complicated aspect is the tax reduction aspect of the deal. That’s handled by virtue of part of the tax code. The tax code section is Section 1031. The way it works is that it provides what in essence is an interest free loan from the Federal government.
About now, you’re asking how this is possible and you never heard about it before this. That doesn’t matter. What counts is that it does exist and there’s no reason you shouldn’t take advantage of it.
The first thing is that you must be selling one property and replacing it with another worth more than the one you’re selling. See–you’re already raising the value of your asset base!
Next, you must close BOTH transactions within no more than 180 days of each other. On that point the government is VERY insistent! Miss the number of days by even a single day and the whole house of cards comes crashing down around you. You’re allowed to close the second transaction in less than 180 days, but don’t even think about going over that number! This replacing of one property by another is the exchange referred to in the name of the deal: tax free exchange.
I can hear you already. You’re asking what this has to do with the tax code. The tax code governs the deal because when you sell a piece of real property after owning it for some time and you receive more for it than you paid to originally acquire it, you have a capital gain on that property. That gain is taxable income. The 1031 exchange allows you to defer paying the tax–for as long as you continue to own the new property after you use the proceeds from the sale of the first property to acquire the new one. In essence, the government is letting you use your taxable income on the sale to buy te new property and isn’t charging you any interest for the privilege! How many banks will do that for you?
Wait! It gets better! If you decide to sell the new property somewhere down the road and replace it with another chunk of real estate, the same situation applies. You can do this time after time and defer taxes every time you do so.
Do you ever have to pony up the tax money to the government? ONLY in one situation. IF at any time you decide not to buy a replacement property that uses all of your sales proceeds, you then have to pay the government its fair share. So, you can go along property after property, increasing the overall value of your holdings and the amount of deferred taxes that you accrue. If you stay strictly within the rules under Section 1031, the taxes remain in a deferred status and not immediately payable.
There’s another important thing about the tax deferral in such an exchange. All of the time you’ve been owning the first property, you’ve most likely been benefitting from its depreciation. When you sell, your favorite uncle (that’s Sam) lumps all of the depreciation together and bills you taxes on the total as if it were income in the year you sell. This is called ‘recapture’. Add this tax to the capital gain tax on the property and you may have quite a large tax bill for the year you sell. Under 1031, all of it is deferred. That’s quite a saving!
One further bit of advice–as with anything involving taxes, consult your tax advisor before going forward. He can not only advise on the exchange, but, as your advisor, will know best how all of this relates to you.
Oh, yes! You may need the assistance of a Realtor to handle the sale and purchase of the real estate. If you need advice in this regard, or an agent to help, give us a call. We have experience in helping people like yourself with these types of transactions, and are quite comfortable coordinating with folks’ tax advisors to those peoples’ best advantage.
Give us a call! The numbers: Peter: (415) 279-6466; Jane: (415) 531-4091. You’ll be glad you did!