As an investor, it’s always prudent to consider which exit strategy you will use before purchasing a property.
This is particularly true in the commercial real estate, where failing to plan can leave you owing staggering sums of money to the USA in the form of capital gains taxes.
Whether you’re buying a six-plex multifamily or a twenty-story office building, whenever you sell a property and receive more than you paid for it, you are liable for capital gains taxes.
On the other hand, if the profit from the sale of the property is less than the cost base (what you paid for the property plus incidental costs, costs of ownership, improvement costs and title costs), then you are not liable for capital gains taxes, but have instead what is termed a “capital loss.”
How To Legally Avoid Paying Capital Gains Taxes
One of the best ways to legally exempt yourself from paying capital gains taxes is to take the profit made from the sale of the property and reinvest it in another property.
This is called a 1031 exchange, and there are certain critical guidelines you need to follow. But as long as the new property costs the same or more than the property that was sold, you will be exempt from paying capital gains taxes.
Keep in mind that this means your capital gains taxes are deferred; technically, once that property is sold again, you will be liable for capital gains taxes again if the price of the new property is less than the amount you received from the sale of the previous property.
Why Do A 1031 Exchange?
- You can defer capital gains taxes indefinitely
As long as 1031 is structured correctly, you can defer capital gains taxes almost indefinitely. Instead of paying taxes on your profit, the government is basically giving you a “loan” to use in the purchase of a new property- with no interest!
- You can trade up or down in terms of investment properties
A 1031 exchange allows you to “trade” in one property for another.
For example, if you have a high-risk office tower and want to lower the risk (and maintenance) of your overall portfolio, you could sell the tower and re-invest the money in several triple net lease properties.
- You can easily diversify your portfolio
You can diversify your portfolio simply by exchanging one property for one (or more) properties of a different type.
You’ll have the flexibility to hop on trending areas. Instead of passing up potential investment opportunities in an up-and-coming area, you can sell a property or two and take advantage of a burgeoning market before it’s too late.
- Doing a 1031 Exchange Is Like Getting Free Money
When you do a 1031 exchange the money that would normally go to taxes goes straight to your property.
Whether you use your windfall to purchase a more expensive property or to finance a downpayment, it’s pretty much like getting free money from the USA.
Basic Rules Of A 1031 Exchange
1. You must use a qualified intermediary to perform a 1031 exchange. You cannot perform it on your own.
2. The amount of debt on the new property must be equal or greater than the debt on the older property.
3. You have 45 days after the sale of your old property to find a new one to buy and use in the 1031 exchange.
4. You need to purchase the new property within 180 days of selling your previous property.
5. You can choose as many as three (or more) properties as your replacement properties (the properties that replace the property being sold), but if you decide to purchase more than three, their total cost cannot exceed more than 200% of the value of the original property.
6. Your replacement property must be a “like-kind” property.
The rules surrounding a 1031 Exchange are quite complicated; however, the rewards are well worth it.
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