Paying taxes can make it harder to grow investments, especially when they will be subject to taxation down the road. That is why it is important to know that for every investment there is a way to defer or avoid taxes.
Real estate investors do this through their losses on depreciation, which never actually come out of their pockets, but can show a loss where a profit was actually made.
For investors who want to sell a property that has gone up in value, the best way to defer taxes, perhaps infinitely, would be to take the profits from the sale and engage in what Robert Kiyosaki, best-selling author of Rich Dad, Poor Dad, calls a 1031 exchange.
What is a 1031 Exchange?
A 1031 exchange (also called as a like-kind exchange) is an event that takes place in real estate where a property owner sells a piece of land, a house, or a building, and uses all of the equity to purchase a larger piece of property of the same kind.
Since the gains that were made are being used to buy a bigger investment, all taxes are deferred until a sale is made that does not involve this transaction.
The term “1031 exchange” is used in common language because it is in section 1031 of the Internal Revenue Code that this idea is explained.
It is there that it states that gains taxes will be deferred on properties of the same kind if they are being used in a productive manner, such as a business or investment. This rule does not apply to stocks and bonds.
Important 1031 Rules
Investors have to understand that this kind of deal is not hard, but it does involve a few complications that cannot be avoided:
- Two key deadlines
- Placement of equity
- Use of an intermediary
The deadlines that must be noted by someone attempting to make this kind of deal are 45 and 180 days after the sale of the property that brings in the proceeds for the new purchase.
The 45 calendar-day deadline is when buyers must identify the new property that they want to acquire. If this deadline is missed, the tax deferral is off. After 180 days, the identified property must be bought. These deadlines are concrete, and can fall on a holiday.
The last key to completing a 1031 exchange is using a Qualified Intermediary, also called a QI. The QI must be a person that is an unbiased third party, leaving relatives and business partners out of the loop. The QI will be the one actually securing the purchasing and selling of properties, making sure that it all goes to plan. Rates for such services can be as high as $2,000.
Investors must make sure that their QI is bonded and insured just as they ensure their electrician and plumber are licensed and insured.
Once all of the pieces are in place, real estate investors can turn small rental homes into larger pieces of property without having to pay the taxes on the gains that were made in the sale by growing their portfolios as they expand from duplexes to quadplexes to apartment buildings, or moving from owning a small cabin to a motel to a hotel.
When the original owner passes on, the property can still operate and earn money for the new owner who will never have to pay taxes on the gains until it is sold, if it ever is.