In this article, you will learn about tax-free money, how to tax-defer capital gains taxes, and how to keep rolling your profits over and over forever! A 1031 exchange allows the owner of an investment property to sell it and buy another property while deferring the capital gains tax.
You will spend about one-third of your life working to pay for your taxes. It is by far one of your biggest expenses. By learning the tax rules, you can legally reduce your tax bill and keep more of your hard earned money!
Over the last two centuries, 90 percent of the world’s millionaires have been created by investing in real estate. Clearly, if you want to attain financial freedom real estate needs to be part of your portfolio. Your investment strategy should include a diverse set of investment vehicles which will create a wealth strategy that can weather any storm.
A Quick Definition of a 1031 Exchange:
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code. It allows you to avoid paying capital gains taxes when you sell an investment property. The proceeds from the sale must be immediately reinvested into another property or properties of like-kind and equal or greater value.
What does that mean?:
As long as one property is being exchanged for another real estate holding, it doesn’t matter whether you are selling a home to buy a duplex, an apartment, a piece of land, or a 4 plex. You can even sell one rental home and split the proceeds to purchase two rental homes!
In fact, you can defer taxes on the portion that is being rolled over or the entire gain. The point is that you can defer taxes as long as that money is being immediately reinvested into another piece of property.
Should you decide to purchase a smaller property, resulting in a leftover gain, you will need to pay taxes on that amount. Remember to consult your tax accountant.
If you own a property for a long time, then you will need to recapture the depreciation, which can affect how much you need to pay in taxes.
If a property sells for more than its depreciated value, you will likely have to recapture the depreciation. That means the amount of depreciation will be included in your taxable income from the sale of the property.
As long as you continue to roll the invested amount into another property, you can defer the taxes on the gain until the last sale.
Tax-Free Money Tip:
Properties that have gone through a like-kind exchange are particularly well suited for inheritance gifts.
When you die, your heirs won’t have to pay ANY income tax should they decide to sell the property shortly after your death. This is because the property receives a step-up in value, and the gain goes away upon the death of the owner.
What is a step-up in value you ask?
A step-up is the readjustment of the value of an appreciated asset for tax purposes (upon inheritance). The new value is the market value of the asset at the time of inheritance. Thus, the asset receives a step-up in basis so that the beneficiary’s (i.e. the receiver’s) capital gains tax is minimized.
So if you died, and your heirs sold the property upon your death, the property would receive a step-up cost basis (market value). Therefore, your heirs would not have to pay the deferred taxes on the increase in value.
I love Tax-Free Money!!!
The 1031 Exchange Timeline:
(Photo credit: cwscapital.com)
A Qualified Intermediary:
To qualify for a 1031 exchange, you must use a qualified intermediary. This means that all proceeds from the sale must be transferred to an unrelated party to the transaction.
Typically, an escrow company is used to hold the funds from the sale, while you find and purchase a new (replacement) property.
What if I Need Cash?
If you own an investment property and need to pull out cash, you can always refinance or pull a home equity line of credit (HELOC). Instead of selling your investment property, you can use it as collateral for a loan.
Moreover, the money you receive when you refinance or pull out a HELOC is that it is tax-free! If you were to sell the property, then you would owe taxes on the proceeds of the sale!
Even if you refinance, you can always perform a 1031 exchange at a later date and tax-defer the gains. Just remember to keep the original invested amount in the real estate holding and within the rollover.
The 10,000 Foot Overview:
Through a like-kind exchange, you can keep buying more and more properties as your properties go up in value (all without paying taxes).
You can continue to reinvest the principal amount while benefiting from the monthly rental income (cash flow). The rental income is reduced by the depreciation of the property and is only taxed at capital gains rate.
Real estate really is a miracle investment vehicle!
Make sure to talk to your tax advisor before engaging in a 1031 exchange. This will allow them to guide you through one because the 1031 exchange guidelines are very specific. Additionally, talk to an escrow agent who has experience with 1031 exchanges to get the specific time guidelines.
Tax-free exchanges have very detailed rules that need to be followed to the letter.
Learn the Rules of the Game:
Knowing the tax law and wealth building concepts are critical to navigating your way through the game of finance.
Want to learn other tax tips that will save you a ton of money and help you retire early? Take the FREE Increase Your Financial IQ Email Course for more information on financial planning and wealth creation!
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