An Introduction to Capital Gains Tax
Perhaps one of the most significant forces acting to minimize profit made in real estate, taxes are the mandatory expenses paid to local, state, and federal governments. Paying them is unavoidable if one is to remain in good legal standing and avoid any sort of penalty from the IRS.
Real estate professionals wanting to save as much money as they can on their taxes may do so by familiarizing themselves with certain tax language and programs designed to make sure adequate funds go back into infrastructure and guarantee “fair play” in economics.
One of these tax programs is the 1031 Exchange (also called a “like-kind exchange” or a “Starker”). Per Investopedia, “capital assets” are “significant pieces of property such as homes, cars, investment properties, stocks, bonds, and even collectibles or art. For businesses, a capital asset is a type of asset with a useful life longer than a year that is not intended for sale in the regular course of the business’s operation.” Investopedia uses the example of a computer being purchased by two different businesses, with one purchasing it simply to sell (making the item “inventory”) whereas the other company bought the item to use in an office (making it a “capital asset”). “Capital gains” are the gains received from the sales of a capital asset, and taxes must be paid on the gains.
But what if one buying and selling properties could defer the taxes owed on the first capital gains acquisition to the next? How could that benefit someone in the world of real estate?
And could such a concept be used to reduce any tax burden for one buying a property?
The 1031 Exchange – How It Works
Dave Foster serves as the Regional Development Director for the Colorado-based Exchange Resource Group — a national Qualified Intermediary Service that provides 1031 Exchange services exclusively. He is also a real estate investor that has used the 1031 Exchange in his personal investing. Dave works as an instructor of various classes teaching 1031 Exchange strategies through realtor associations throughout the U.S., and offers personal experience that covers two decades of doing business in real estate.
Foster spoke to GREEN about the 1031 Exchange, offering basic insight for the blog’s readership. According to Foster, the 1031 Exchange is “A process named for its place in the IRS code (sec 1031) that allows investors sell investment property (both real and personal) and then purchase new investment property without having to pay tax on the gain from the sale. It is a very specific process managed by a qualified intermediary. But for the investor it is simply selling and then buying investment property under the guidelines. The gain is deferred into the new property so the taxpayer can use the tax dollars normally due to the IRS to help purchase their new property.”
TurboTax’s website adds that “And as the Internal Revenue Service points out, just about everything you own qualifies as a capital asset.” This means that almost anyone can deal with capital assets, and the gains associated with them. Dave Foster explains that the use of the 1031 Exchange isn’t just limited to real estate professionals. “Anyone or any tax paying entity that owns investment property that has profit in it may take advantage of a 1031 exchange” he says. “It is one of the very few opportunities within the tax code where you can sell for a profit and not pay tax on the gain. Regular folk, casual landlords, professional investors, and large real estate companies all benefit equally from 1031 exchanges.”
The amount of money saved on a 1031 Exchange can keep a major percentage of profits earned on real estate business with the seller. “So saving 20 – 40% of the profit is very common,” Dave tells GREEN. “On a sale with $50,000 in gain that translates to a tax savings of as much $20,000 which is then used to purchase more investment property.”
If that process is repeated multiple times in a period of a year, the amount of money saved may offset even the most extreme losses for a fiscal year. Using the 1031 Exchange isn’t restricted to a single instance, and may be used in a repetitive fashion to create a “daisy chain of savings.”
“There is no limit on the number of exchanges on qualifying property,” says Foster. “And as long as the investor continues to own that property or does another 1031 exchange when selling they will never have to pay the tax on all of the gain built up over the years. This can literally translate into hundreds of thousands of dollars of tax that the investor is allowed to use for investment rather than paying the government.”
Properly Identifying the Properties
The moniker of “like-kind” alludes to information provided by the API Exchange that an identification of the next property to which the 1031 Exchange tax deferment should be targeted must be identified within a 45 day period, with the period starting “on the date the Exchanger transfers the relinquished property,” and subsequently ends 45 days later at 12:00 a.m.
Per the API Exchange, there are several tax code requirements that must be met for the property to be identified. The Exchanger must deliver a signed, handwritten document that is mailed before the end of the identification period to a person involved in the exchange or a person who handles such exchanges professionally (i.e., a “qualified intermediary” like Foster). This identification notice must have an “an unambiguous description of the replacement property (i.e., legal description, street or distinguishable name), the address of the relinquished property, and the type of the property to be exchanged. If someone is acquiring a property currently under construction, both the property and the improvements must be identified in as much detail “as is practical at the time the identification is made.” Also, exchangers that expect not to get full ownership interest in a replacement property must disclose the specifics of the percentage interest.
Furthermore, there are stipulations associated with “the maximum number of properties that can be identified as understood using three principles:
- “The 3 Property Rule” that states three properties may be listed “without regard to their fair market value;
- ”The 200% Rule” that any number of properties may be listed “so long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of all relinquished properties”, and
- “The 95% Rule” that any number of properties may be listed without regard to their combined fair market value as long the properties acquired amount to at least ninety five percent (95%) of the fair market value of all identified properties”.
Correcting an identified property with the identification period allows for a “backup plan” in case the target property was purchased from the one wanting to use the 1031 Exchange. In such a case, the one making the 1031 Exchange may select another property for purchase. Listing multiple properties as possibilities for the Exchange helps reduce the chance of not getting a qualified property.
Tips on Using the 1031 Exchange
As education in real estate is the mission of GREEN, readers of the blog are always reminded to seek the advice of an experienced mentor from which you can ask specific questions. The 1031 Exchange is no exception to this, and requires the person executing the exchange to use qualified help from people like Dave Foster.
In a blog for his Florida Real Estate Attorney Firm, Ron Webster offers “The Seven Essentials Every Seller Should Know,” each of which are defined as requirements. The seven requirements include an honoring of the terms of the “rollover,” that the purchase of the property be made in 180 days from the first day of the initial identification period (the 45 day period) to qualify for a 1031 Exchange, and that the person using such an exchange reinvest an equal or greater amount.
Forbes also tells it’s readership that “special rules apply when depreciable property is exchanged in a 1031.” The article speaks to the “depreciation recapture” that gets “taxed as ordinary income, and the example used is exchanging improved land with a building for unimproved land without a building (as the prior claim of depreciation reverts to ordinary income, since there is no depreciation in the process).
“There some very rigid requirements that all must be met for an exchange to qualify,” Foster adds. “A 1031 exchange is not a DIY project. It requires the use of a professional to facilitate and manage the process. This individual is called a ‘qualified intermediary. Since a 1031 requires the use of a qualified intermediary and the intermediary must be in place prior to the sale, you need to plan earlier rather than later. The law is quirky and murky and you want to select a professional who has the depth of experience of years and numbers of exchanges.”
Those wanting to learn more about how to use the 1031 Exchange are formally invited by GREEN to visit Exchange Resource Group’s website to learn tips and receive professional consulting from 1031 experts like Dave Foster.