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Tax Strategies
1031 Exchanges: A Tax-Deferred Real-Estate Strategy
by Loic LeMener (Write for us!)
(Click on the links within the article to get definition of that word)
When the time comes to sell your real estate, some owners of highly
appreciated realestate could be staring at a substantial capital-gainstaxbill. A section of the Tax Code may help you convert your appreciated property into an income stream-while deferring up to 100% of the capital-gains tax that would otherwise be due on the sale.
The current capital-gains tax savings could be substantial. In addition to the federally imposed capital-gains tax of 15%, any gain on the sale of a property could otherwise be subject to state income tax. That means your total tax bill could run as much as 20% or higher.
In addition to the tax deferral, 1031 exchanges may provide real-estate owners with an opportunity to help improve their lifestyles -for example, by exchanging a highly management-intensive property for one or more properties that are less demanding to manage. These transactions can be beneficial to real-estate owners with appreciated properties that make up 5% to 50% of their networth.
Reduced Stress and a Higher
Level of Potential Income
It sounds simple enough, but with the Tax Code, there is always a hitch. In this case, the IRS has set out a long, stringent set of guidelines that definequalified transactions. But the principalissue is that proceeds from the sale of one property must be reinvested in a "like-kind" replacement property within a certain amount of time to avoid taking that tax hit. These properties don't have to represent a one-for-one swap.
Investors can use the sale from one property to buy tenant-in-common, or TIC, interests in a variety of different properties, opening up an opportunity for strategic planning. For instance, investors who prefer to take a less active role in real-estate management can trade a high-maintenance portfolio of rental properties for hands-off interests in other commercialventures.
Through what's known as a TIC transaction, you can reinvest the proceeds of those exchanges into a non-management, fractional interest in a larger commercial property. You get a share in the rental income without having to assume any responsibility for the day-today management of the property.
This option is particularly attractive for investors looking to boost income potential. The 1031 exchange may end up generating a higher level of income for the property owner than they had earned on the previous property. More importantly, you may be able to have a more diversified real estate portfolio than you might have had to begin with.
For instance, consider the case of a real estate owner who plans to reinvest the proceeds from a $5-million property into a $3-million property. The owner also plans to distribute the remaining $2-million in proceeds from the exchange across a variety of TIC investments. With the exchange of a single $2-million property, the owner could invest in
as many as eight different TIC properties, assuming a standard $250,000-minimum investment in each TIC transaction.
Putting the 'Estate' in Estate Planning
TIC exchanges may have the ability to be customized to fit into a real estate strategy. For instance, you may be able to increase your cash flow by exchanging a piece of raw land and investing in one or more income-producing properties. Or you could possibly decrease your current tax liability by exchanging a fully depreciated property and using those gains to buy more leveraged property, thereby increasing your depreciation expenses.
TIC exchanges may be a particularly important part of an estate plan in which the primary asset is a single piece of property-for instance, a family farm that future generations don't want to maintain. The owner can exchange that land and then divvy that money up into several smaller properties. After the owner's death, each heir will inherit their own piece of property that they can manage as they see fit. And with the death of the owner, the heirs receive a one-time step-up in cost basis, effectively erasing the deferred taxliability.
As with any valuable asset, managing the exchange of real-estate tax efficiently is a complexundertaking. But with a 1031 exchange you may be able to diversify your holdings without any current capital gains tax liability.
A 1031 Exchange is available to accredited investors only. ($200,000 yearly income and $1,000,000 net worth). A 1031 exchange may be subject to special risks including illiquidity. A 1031 prospective investor should consult with their own legal, tax, accounting and financial advisor before investing as tax advantages may be lost if not executed within
established time constraints. A 1031 exchange prospective investor should carefully consider the charges, expenses and risks of a 1031 exchange and whether it is appropriate for them based on their financial situation, objectives and time constraints.
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