The Tax Man Cometh: Deferring Taxation With a 1031 Exchange, Part 1

Real estate investing can be a lucrative wealth building strategy, both for people who want to live on their rental income now as well as those who are looking to build up their portfolios for a more distant goal. Unfortunately, one of the chief downsides to being a successful investor is the increased tax liability that comes with it. There are many ways to reduce or defer your tax burden depending on the type of investment gains you earn. By investing through a self-directed IRA (SDIRA) or Solo-401K, for example, you can keep all your rental income safely tucked away in a tax-deferred account until after retirement…but that’s a topic for another post. While income taxes on rental income are a nuisance, to be sure, but what about that whopping bill that comes due when you sell a property at a profit?

While turnkey properties are meant to be long-term investments, many investors dabble in multiple real estate niches, downsize their primary residence to free up the equity for investing, or decide to sell a property that has appreciated in order to roll those funds into higher ROI cash-flow rentals to build passive income. In short, there are any number of reasons you may elect to sell a property and, when you do, you want to be able to make the most of those profits. However, depending on how long you have owned the property, your income level, and what other capital gains or losses you incur during the year, you could owe a sizeable chunk of those returns to the government.

There’s no such thing as a free lunch, as they say, and taxes do serve a vital purpose by funding roads, schools, libraries, and other important infrastructure necessities. But that doesn’t mean you need to cut a huge check to Uncle Sam every time you turn a profit. If you play your cards right you can easily, and legally, defer your tax burden and maximize the buying power of your existing equity.

Let’s Talk Rates

The bottom line is that any gains you make on the sale of real estate are taxable. There are a number of factors that determine the rate of taxation and various caveats that can increase or decrease the total amount owed, but in most cases, the following rules apply:

  • For most people, long-term capital gains earned on the sale of property you have owned for more than one year are taxed at 15%, except….
  • If you have income of more than $415,050 for an individual or $466,950 for a married couple filing jointly in 2016 and are therefore in highest 39.6% income tax bracket, then your net capital gain is taxable at the highest 20% rate. But…
  • If you are in the 10% or 15% ordinary income tax bracket, your capital gains tax rate is 0%. However…
  • Capital gains earned from the sale of investment real estate for which you have previously claimed tax deductions for depreciation can be taxed at a 25%. Basically, if you claim property depreciation on your taxes then, when you sell that property, a portion of your profit equal to the amount of your prior deductions (called ‘unrecaptured Section 1250 gains’) is subject to this higher rate, while the rest of your gain is taxable at the regular long-term gains rates according to your income tax bracket.
  • If you have owned the property for less than one year, then any net gain is taxed as ordinary income, up to the maximum rate of 39.6%. The holding period for property begins the day after you receive the title.

The Tax Man Cometh 02

While holding property for more than a year can reduce the amount of tax you owe on a profitable real estate sale, the tax burden of even long-term gains can be substantial. If you buy a house for $250,000, for example, and sell it ten years later for $500,000, then that $250,000 gain is taxable as a long-term gain. If you are in the 28% tax bracket and do not have any capital losses with which to offset this gain for the current year, then you’d owe the full 15%, or $37,500, or more if you’ve claimed depreciation in prior years. That’s more than the down payment on a stellar new turnkey property!

The Secret Weapon: 1031 Like-Kind Exchanges

Any shrewd investor will tell you that leaving money on the table for the IRS is not the best way to build wealth. Yes, eventually the tax man will come calling, but until then, you could be using those dollars to generate returns on new investments.

When it comes to real estate, the best way to keep your equity working for you is to use a 1031 exchange, so catchily named for the section of the IRS code that outlines its terms. A 1031, also called a ‘like-kind’ exchange, is simply a method by which you can use the funds generated by the sale of property to purchase another piece (or pieces) of property of equal or greater value, thereby reinvesting your equity into a new asset and deferring taxation on the original sale.

1031 Exchange Basics: Playing By The IRS’ Rules

The-Tax-Man-Cometh-03http://www.spartaninvest.com/wp-content/uploads/The-Tax-Man-Cometh-03-150x100.jpg 150w, http://www.spartaninvest.com/wp-content/uploads/The-Tax-Man-Cometh-03-300x199.jpg 300w" sizes="(max-width: 325px) 100vw, 325px" width="325" height="216">On the surface, a 1031 is pretty simple. First, you decide to sell a piece of property and reinvest those funds into another property. You must follow guidelines regarding how and when to identify like-kind properties for purchase and file appropriate documentation specifying your desire to execute a 1031 exchange. When you sell your property, the funds are transferred to an intermediary who holds them until you purchase your new property, at which time the funds are transferred to the seller and your exchange is complete.

If it sounds deceptively easy, it is and it isn’t. Using a 1031 is perfectly simple – if you adhere to the IRS’s strict requirements, of course. There are a number of crucial requirements that must be considered before you can move forward on a 1031 and a few deadlines that can make or break your deal, so understanding the nitty gritty of a this type of transaction is imperative. If you neglect to file correct documentation, miss a deadline, or otherwise violate any of the IRS’ many rules and regulations, the whole exchange is void and you’ll owe every penny of your original tax bill and likely be on the hook for the purchase of a new property as well.

To Be Continued…

All that being said, a 1031 exchange can still be a very powerful tool in your investing arsenal, especially if you don’t have a ton of extra capital lying around and need to borrow Uncle Sam’s cut of your profits to continue building your portfolio. In our next post, we’ll explore the specific requirements of 1031s and how you can ensure that your transaction goes smoothly, so check back soon!

In the meantime, if you have any questions about what we do, the turnkey industry, or why Birmingham is a great place to begin building your real estate portfolio, drop us a line any time!

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