Say you have invested in a property with the intent of buying and holding. You hold it for a few years, adding value to and paying taxes on the property. When it comes time to sell that property, it has appreciated in value. You sell your property for a healthy profit and walk away with full pockets. This oversimplification of real estate investment and market dynamics would have most novice investors believing that the only real property investment advice they need is that pertaining to marketing and adding value to a property.
However, the big picture starts to look very different when you start to account for property taxes. If you profit from the sale of an investment, you are required to pay a capital gains tax. That tax can end up significantly detracting from the value that you derive from your investment. If you don’t take advantage of the tax benefits available to real estate investors, you may end up investing more time and energy than the sale was worth. Is investing really worthwhile if the money you make doesn’t actually end up in your pocket at the end of the day?
Lucky for investors, 1031 exchanges provide a cushion against tax-related losses by eliminating the capital gains tax. Perhaps some of the most valuable property investment advice thus pertains to leveraging the 1031 exchange.
For investors, a capital gains tax is a federal tax levied against investment profits, which qualify as capital gains. But capital gains taxes are not just reserved for real estate investors. Instead, they actually apply to the purchase and resale of any asset, so long as it generates profit that qualifies as a capital gain. And most forms of resale profit qualify as capital gain. In fact, capital gains taxes even apply to personal property. And almost all of your personal and investment assets will qualify as capital assets.
Capital gains acquired within less than a year of the initial purchase are considered short-term capital gains. Likewise, capital gains from an asset that you held for over a year qualify as long-term capital gains. Short-term capital gains are generally subject to a 10-20% higher tax rate than long term capital gains. Thus, buying and holding may have a significant advantage over fixing and flipping in the realm of taxes, and thus prove more profitable overall. Further, fixing and flipping capital gains are not subject to a 1031 exchange.
In most cases, the value of your final sale minus the value of your initial purchase is considered your capital gain. In such instances, the value of your initial purchase is considered your “basis.” You can actually reduce the value of capital gains by including the cost of increasing the value of the asset into your basis. You can also add the value of taxes and fees levied on the acquisition of your asset. But if you want to avoid capital gains entirely, the most sound property investment advice is to look into a 1031 exchange.
A 1031 exchange, as delineated in section 1031 of the IRS code, renders investors exempt from a capital gains tax so long as they reinvest their capital gains from one property in another property. Thus, if you are a one-time investor trying to turn a profit for a specific purpose, you probably won’t find much use in a 1031 exchange. However, if investing is your profession or long-term plan, a 1031 exchange could hugely impact your personal finances.
Over time, a 1031 exchange enables the accumulation of greater and greater profits. When your profits are subject to capital gains taxes, you will only be able to re-invest a fraction of your profits. That means re-investing in a lower-value property for what will likely be a far smaller profit than if you had avoided the capital gains tax and were able to invest in a more valuable property. A 1031 exchange therefore permits the exponential expansion of your portfolio and net worth.
A 1031 exchange can be beneficial to investors with a diverse array of objectives. You might be seeking to invest in a property with greater return potential than your current property. Perhaps you wish to diversify your assets. You may be looking to invest capital gains in a property that would exempt you from property management. You may wish to either increase or decrease the number and value of assets that you hold, perhaps by investing capital gains in multiple properties. In general, a 1031 exchange provides greater capital flow for investing purposes, thus increasing your earning potential.
Furthermore, a 1031 exchange acts as a safeguard against the negative affects of depreciation. In the short term, depreciation actually decreases the value of your taxable income, saving you money. However, you may be forced to recapture the value of that depreciation if you are able to sell your property for an amount that exceeds it’s initial purchase price plus the cost of appreciation and minus the cost of depreciation. However, if you use a 1031 exchange and reinvest your capital gains, you will not have to recapture any depreciation.
Finally, a 1031 may be highly beneficial if you have suffered significant capital losses. Your capital gains minus your capital losses equal your net capital gain. Using a 1031 exchange, you reduce your taxable net capital gain, meaning fewer taxes. If doing so results in a negative capital gain, you may be compensated for your capital losses in addition to eliminating taxes on your gains.
1031 exchanges apply to almost every type of real estate. If you own commercial properties, single family homes, apartment complexes, etc., you probably qualify for a 1031 exchange.
There are a few stipulations concerning the way you conduct your exchange:
Our property investment advice? Identify the new transaction before you sell the old one. You only have 45 from your sale to identify the new property. If you can’t find one in that period, you lose the exchange.
The nuances of property taxes are many and complicated. Consult with a financial advisor to determine if you qualify for and would benefit from a 1031 exchange.
If you are re-investing capital gains, you are not permitted to transfer those gains to the seller of your next investment. Instead, you must operate through a qualified intermediary. That’s because, so long as you continue to hold your capital gains, they remain taxable. A qualified intermediary is an individual or company that will hold your capital gains and transfer them to the seller of a property to facilitate the 1031 exchange.