1031 Exchange Strategies for the Long Term Investor
December 17th, 2007 by amirshahkarami1031 Exchange Strategies for the Long Term Investor
Section 1031 of the Internal Revenue Code is one of the most powerful wealth building tools available to investors. Section 1031 allows investors to defer payment of capital gains taxes on the sale/exchange of a business or investment property.
The deferral of taxes means more purchasing power for the investor and the ability to more quickly build a better and larger investment portfolio.
Building a Tax Snowball
Long term planning is crucial for investors planning a 1031 Exchange. Although taxes can be deferred in an exchange they will not be forgotten. The gain deferred in a properly structured 1031 Exchange will reduce the tax basis in the property acquired in the exchange.
For example, let’s assume an investor with a $500K gain on the sale of a property can defer taxes by exchanging into a property with a net purchase price of $750K. Generally, a property’s tax basis is the property’s net purchase price. However, when exchanging, the gain will offset the basis, so in our example, the new basis is $250K. A sale of the new property above $250K will result in a taxable event
If the investor has done several exchanges over the course of many years, they may face a large (and unexpected) tax liability when it is ultimately time to stop exchanging and “cash out”. Therefore, it is of utmost importance that investors know how the tax laws work and plan appropriately.
Strategies for Avoiding Taxes over the Long Term
Proper planning can help minimize and potentially eliminate most taxes owed. Investors can utilize two strategies to reduce their tax liability:
Convert To Primary Residence (Section 121 Strategy) - A 1031 Exchange investment property can be converted into a primary residence and upon disposition be eligible for the homeowners exemption. This strategy can eliminate taxes on up to $500K of gain for married couples, or $250k for singles. Converting an investment property into a primary residence can be tricky, so it is wise to consult with a tax advisor. Although not a substitute for proper tax planning with an advisor, here are some helpful tips to consider.
Rental Income - Before being converted into a primary residence, the investment property should have reported rental income for at least 12 months so that the validity of the original 1031 Exchange is not challenged by the IRS. 12 months of rental activities should be considered a minimum, the more time held as a rental, the better.
Use and Ownership - Once converted into a primary residence the owner is not eligible for the homeowner’s exemption until the property has been owned for five years, and has been used by the owner as a primary residence for at least two out of the past five years.
Death (Estate Planning Strategy) - Upon death, owners of real property will pass the property on to heirs at a stepped-up tax basis. With a new stepped-up basis, the capital gain earned during the decedent’s life is eliminated entirely. A true death benefit provided by the tax code. For estate planning purposes, many real estate investors choose to incorporate a “defer, defer, die” strategy. Instead of cashing out and paying taxes, investors can 1031 exchange into easy to manage (or management free) properties that produce stable cash flow. The property is held until the investor dies, leaving the asset to their heirs at a stepped up basis and eliminating the entire capital gains tax liability.
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