Is a 1031 Exchange For You?

Is a 1031 Exchange For You?

If you invest in real estate, I'm guessing you want to grow your wealth as much and as fast as possible. One of the things holding you back is taxes. 1031 exchanges provide a loophole you can use to accelerate your wealth building...

The 1031 exchange, also called 1031 tax deferred exchange, 1031 like kind exchange and Starker Exchange is a provision in the tax code that gives you a way to defer paying capital gains tax.

What is a 1031 Exchange?

The 1031 like kind exchange is a way to essentially "trade" one property for another without having to pay capital gains taxes on the transaction.

For example, if Joe bought a rental house for $100,000 and later sold it for $150,000, he'd show a capital gain of $50,000. At the prevailing rate as of this writing, Joe would owe $7,500 in capital gains tax.

If Joe used the proceeds to buy another rental property for $150,000, he could do a 1031 exchange and defer paying the taxes. Joe could continue exchanging properties indefinitely.

Why Do a 1031 Exchange?

In his book "Exchanging Up", Gary Gorman offers the following:

[Begin excerpt]

There are probably as many reasons why people do Exchanges as there are Exchanges being done. Nonetheless, we see some classic patterns when people Exchange property.

Increase Cash Flow. By moving from one property to another, a person can create or increase monthly cash flow. For example, if Fred sells a piece of bare land, with negative cash flow because of property taxes and insurance, he could Exchange into a piece of income-producing property (like an office building) that provides net rental income from the rents minus expenses. Fred can use an Exchange to create positive cash flow.

If Sue sells her purple duplex, which provides her with positive monthly cash flow of $500, and Exchanges into a different property that will give her positive monthly cash flow of $750, Sue's cash flow will increase by 50 percent (or $250) by doing an exchange.

Job Relocation. If Sue takes a job transfer from California to the company headquarters in Connecticut, Sue can move her rental property with her by selling her purple duplex in Los Angeles and buying a replacement rental property in Connecticut.

Using the Tax Monies to Leverage Up. By doing an Exchange and not paying the tax, the funds that would have gone to tax payments are now available for you to acquire larger replacement property without taking on additional debt. For example, if Sue's gain on the sale of her purple duplex is $100,000, her combined federal and state tax will run between $25,000 and $35,000 (or more) depending on what state Sue lives in.

By doing an Exchange, rather than selling the duplex, paying the tax and using the net proceeds to buy the New Property, Sue can buy a larger New Property. For example, let's assume the tax would only be $25,000 and let's assume that the lender will loan Sue 75 percent, if Sue puts down 25 percent. By doing an Exchange, Sue will have an extra $25,000 that would not be available to her if she paid the tax. The lender will loan Sue an additional $75,000 against this $25,000, allowing Sue to buy an additional $100,000 of property - more than she would be able to if she paid the tax.

If the value of her property doubles over the next ten years, Sue's additional property will grow to $200,000 in value. If she sells the property after ten years and pays back the $75,000 loan, the tax she didn't pay (of $25,000) will have created $100,000 of wealth for Sue (after paying back the loan of $75,000, she'll have $125,000 left, including the $25,000 of taxes deferred from the original sale). Sue used the tax money to leverage up.

[End excerpt]

Standard CYA: This article is provided for information purposes only. Get qualified advice from a competent professional regarding application of this information to your own situation.

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