Seasoned real estate investors know that the home they live in provides a proper tax shelter for part of their money. But what about their fix-and-flip and rental properties? It is no shock that they might have to pay a capital gains tax when they flip a home. However, there are ways around it that are entirely legal.
Seasoned investors use 1031 exchanges and other methods to minimize their tax liability. Read on to learn how seasoned investors leverage the 1031 exchange as a tax shelter.
Learn To Use A 1031 Exchange Properly To Defer Capital Gains Tax
When selling an investment property for a profit, you must pay capital gains tax on the proceeds. Depending on for how much you sell the property, you might, in fact, pay more in taxes than the profit from your sale. The 1031 exchange allows you to defer paying capital gains tax. But that’s as long as you reinvest the funds into another investment property within 180 days of the sale.
It is a savvy move that a lot of seasoned investors use to gain much more leverage from their portfolio. It enables you to invest in other property that could put $ in your pocket.
To efficiently execute a 1031 exchange, you will have to keep the following in mind – and also consult a tax advisor for further directions and for a greater chance of success:
1. “Like-Kind” Property
You must exchange properties for “like-kind” properties. “Like-kind” means that both the sold property and the purchased property must be of the same nature and character, although they can differ in quality and grade. To be more specific, you can sell a duplex and purchase five cottages, or sell a single-family home and purchase a multi-dwelling unit. But you can not sell a property and buy, say, a fleet of vehicles. Also, you can not include your primary home in any part of a 1031 exchange.
2. Greater or Exact Value
The net market value of the sold investment property has to be exact as, or greater than, the bought property. If it is not, then the federal government will obligate you to pay capital gains tax on the difference. But there is good news. The inspection expenses, broker fees, and any other costs linked to the purchase can often count toward the value of the new property.
3. Identify Potential Properties
You need to identify potential properties to buy within 45 days of closing on the sold property. You will have 180 days to close the purchase on the new investment property, but you need to have three potential properties lined up within 45 days.
Here is another secret that only seasoned investors know. If the investment property you want to buy turns out to value less than the one you sold, then you can do a building/improvement exchange. Just roll a loan for renovations into the buying value to defer all the gain taxes on the sale of your property.
What is a “Boot?” Here’s an example. Let’s suppose that you are selling your property for $10 million. However, you want to hold on to some of the money so you decide that the real estate property you will buy is only worth $9 million. The “Boot” is that 1 million you chose to keep.
The taxpayer must not receive a “Boot” in order a 1031 exchange to be 100% tax-free. If they do receive, then it will be thought taxable, and you need to pay capital gains taxes on this. Even though this alternative does not provide an entirely tax-free 1031 exchange, still seasoned real estate investors commonly use it.
5. Changing the Name on Your Title
When somebody buys a new property, the tax return, and the name that is on the title of the sold property, has to match that of the new property. With that said, you can make an exception of this when doing 1031 exchange through means of an SMLLC or Single Member Limited Liability Company. This kind of 1031 exchange is often seen as a “pass-through” to a member and enables the Single Member Limited Liability Company (SMLLC) to sell their property to buy a new one in their individual name.
To have a better vision for the compelling benefits of a 1031 exchange, we give you an example:
Let’s suppose that a real estate investor has $200,000 capital gains and incurs a tax liability of around $70,000 in combined taxes (state and federal capital gains taxes, depreciation recapture) when they sell the property. There are only $130,000 left to reinvest in a new replacement property.
If we suppose a 75% loan-to-value and a 25% down payment ratio, then the seller would be able to buy only another property worth $520,000.
If the same seller decides to participate in an exchange, they would be able to reinvest the full $200,000 of equity in the $800,000 purchase in real estate, supposing the same loan-to-value and down payment ratio.
This instance points out how a 1031 exchange protects the real estate investors from capital gains tax and enables them to facilitate high portfolio growth and an increased ROI (return on investment).
Understand How To Appreciate Depreciation
A lot of investors do not understand how depreciation of rental properties works. And that might cost them a bundle come tax time. You can deduct any improvements on the residence over the lifetime of that building. Moreover, you might be able to depreciate the building itself.
Invest in Your Business and Help It Grow
Investments in your business, (while not precisely “tax shelters”), are always a great way to minimize tax liability. From advertising expenses to legal counsel, you may be surprised just what deductions you can take.
To find out what you can or cannot deduct legally and to make sure that you are executing a 1031 exchange properly, please consult with your tax attorney or CPA.
If you had a bad investment that did not turn out the way you planned it to, and now selling would cost more than you would profit, then now is the right time to use a 1031 exchange to save your investment. When you utilize a 1031 exchange in order to get a new investment property, you take the full sale of the property and place it on a new property. That will allow you to avoid losing more $ on that messed up investment.
The best thing about selling a property is, of course, the profit. But what a lot of new investors, and even smart professionals, can overlook when counting their earnings, is how much cash is going back to the state in capital gains tax. Every real estate investor, whether new or seasoned, needs to consider this when deciding to sell.
If you have any questions, please do not hesitate to call Westwood Net Lease Advisors. We will be glad to help you out.