How Real Estate Investors Can Pay Zero Taxes! - Part 1 A Tax Dollar Saved is a Dollar Compounded
Yes, we live in a country founded on a capitalist philosophy, but
somewhere along the line the government has become the enemy of
financial success. How and why that has happened is not the issue for these
pages. The question is, can you do anything about it? Can you protect
yourself from greedy, irrational tax laws? The answer is a resounding,
“Yes!”
The skillful investor prides himself on making good investments that
will grow in value. But that’s not enough. To secure financial independence
in the shortest amount of time one must allow their gains to grow at a
compounded rate. The problem is that Uncle Sam is your partner and he
takes a bite out of your gain in the form of capital gains tax, leaving you
with less to compound. Like this:
The capital gains tax rate changes from time to time, but use 20% as
an example. If you have a $10,000 gain Uncle grabs $2,000 as his share.
That leaves you $8,000 to rollover into another investment.
$8,000 invested at a 20% rate of return for 10 years equals $58,150.
If you could avoid paying that $2,000 tax look at the result:
$10,000 invested at a 20% rate of return for 10 years equals $72, 680.
That $2,000 of capital gains tax will cost you $14,530 over a ten-year
period of investing. (We will ignore any state tax that might be due.)
Add a zero onto all of those numbers and the tax would slip $145,000
out of your pocket! That’s not nice!
That brings is to the three keys of successful investing:
1.
1. Leverage – control great value with a small capital investment.
2. Force the growth of that value through knowledgeable management.
3. Magnify the compounding of gain by legally avoiding taxes.
Real estate allows the investor to take advantage of all three keys.
The strategy lest understood by the average investor is the power of a 1031
Exchange. That part of the tax law will allow you to build wealth, while
deferring the payment of all capital gains taxes. No taxes = greater
compounding. Greater compounding = maximum capital accumulation.
In prospers times any dedicated real estate investor can build an
investment portfolio worth one to many millions of dollars. Can that create
estate problems? Yes, but only if you are not aware of some advanced
estate-planning techniques.
This manual will suggest how you can build great wealth and then
pass it on to heirs without paying taxes. The Kennedys, Rockerfellers and
Fords do it and so can you.
First lets talk 1031 Exchanging.
What is 1031?
The 1031 Tax deferred treatment of capital gains is one of the best
real estate investing tactics for preserving and building real estate wealth.
Section 1031 of the Internal Revenue Code allows property owners to
exchange their property for other like-kind property. This is the magic
carpet that allows property owners to exchange their property for other like-
kind property and avoid paying a tax on the gain.
A 1031 Deferred Exchange is not difficult if you will carefully follow
the strict rules and timetables proscribed by the IRS. The deferred exchange
is an alternative to a common sale and purchase transaction. If your goal is
to build real estate wealth you must understand 1031 exchanging.
2.
It will allow you to avoid capital gains taxes and keep the full value of your
investment and its increasing worth working for you.
Under 1031 a property that you now own and are planning to sell or
exchange is called “Relinquished Property.
Properties that you are planning to purchase are called “Replacement
Property”.
“Non Recognition of gain” is IRS terminology, which means you do
not have to pay the capital Gains Tax on a transaction.
There are three conditions, which must be met to accomplish nonrecognition
of gain:
1.) The properties exchanged must qualify, and be of “likekind”.
2.) There must be an actual exchange, not a transfer of property
for money only.
3.) The time requirements must be strictly followed.
Before we can discuss just what all of that means we must cover a few
more IRS details.
Classes of Properties
The IRS places real estate into four classifications:
1.) Property held for personal use. (Personal Property)
2.) Property held primarily for sale. (Dealer Property)
3.) Property held for productive use in trade or business.
(Business Property)
4.) Property held for investment. (Investment Property)
3.
The classification of property determines if the property qualifies for 1031
treatment. Numbers 3 and 4 above qualify. 1 and 2 do not.
It is your use of the property that determines the classification. What
the other party does with the property has no effect on your tax situation. If
you exchanged investment property to someone who would hold it primarily
for sale (Dealer Property that does not qualify for 1031) it would not effect
the status of your 1031 exchange tax avoidance.
Like-Kind Property
Remember 1031 exchanges only work with like-kind property. That
refers to your use of the property. If you are using the properties as
investment properties they qualify.
1031 property may be mixed as to type and still be ”like kind”.
Example: You may exchange land for a duplex, commercial building for a
retail store, a home for another home or apartment property, etc.
Property held outside the USA and its territories does not qualify for
exchange with property held within the USA.
The Tax Reform Act of 1984 made it very clear that partnership
interests cannot be exchanged and qualify for deferred gain treatment under
1031 rules. The regulations also interpret no difference between general
partnership interests or limited partnership interest. Although actual
partnerships can exchange with other partnerships under the shelter of 1031,
the exchange of an individual interest is prohibited.
However, the Omnibus Budget Reconciliation Act of 1990 did amend
1031 to incorporate the use of IRC 1.761-2(a), Election of Partnerships, to
not be treated under Subchapter K of Chapter 1 of the Code, for the purposes
of taxation. What?
That simply means that if every individual or entity within a
partnership, elects to have his individual interest treated as his or her own
real property interest, similar to a tenant in common interest, then that
individual interest can qualify to be exchanged under 1031.
4.
Since that partnership interest can qualify for deferred gain treatment, the
amount realized from the sale of that interest could be used to acquire any
qualifying replacement property.
Now an interest from a partnership in which all partners have made
individual elections under 1.761-2(a) can be exchanged for any other
property. And, there is no requirement that the investor exchange into
replacement properties with his or her previous partners, only that the
exchange be used for investment purposes only and not for the active
conduct of business.
Time Limitations
The 1031 exchange rules have two time limitations:
1.) The period of time to identify the replacement property begins on the
date of closing of the exchange property and ends 45 days later. The
replacement property must be identified in writing, and delivered to the
intermediary by midnight of the 45th day after the closing of the relinquished
(exchange) property. In identifying the replacement property it must be
unambiguously described. You should use a legal description or a specific
street address.
2.) The period of time in which the replacement property must be received
by the exchanger begins on the date of closing of the exchange property and
ends on the date that the tax return of the taxpayer is due, including
extensions or in 180 days, whichever is earlier.
Replacement Property
“Replacement Property” simply defines the property or properties
intended to be purchased with the funds that are received from the sale of the
relinquished property.
Meeting the technical requirements of identification is critical. You
must satisfy one of these rules:
5.
1.) The Three Property Rule dictates that you may identify three properties
of any value, one or more of which must be acquired within the 180 Day
Acquisition Period.
2.) The Two Hundred Percent Rule dictates that if four or more properties
are identified, the aggregate market value of all properties may not exceed
200% of the value of the relinquished property.
3.) The Ninety-five Percent Exception dictates that in the event the other
rules do not apply, if the replacement properties acquired represent at least
95% of the aggregate value of properties identified, the exchange will still
qualify.
These identification rules are absolutely critical to any exchange. No
deviation is possible and the IRS will grant no extensions.
The replacement property must have a value equal to, or greater than,
the relinquished property. All of the proceeds from the relinquished property
sale need to be invested in the replacement property. The gain will be
taxable only to the extent that these goals are partially achieved. If all the
goals are accomplished, the entire gain will be deferred.
This means that if you sell a property for $200,000 and acquire a
replacement property for $180,000 you would have to pay tax on the
$20,000 that was not reinvested in the replacement property.
Replacement properties can be revoked as long as it is done within the
45-day identification period. This revocation must be done in writing and
should include a rescission of a purchase and sale agreement, if one was
created.
Replacement property is treated as received before the end of the
exchange period if:
1.) You actually acquired the replacement property. That is, closed the
transaction prior to the end of the exchange period (180th day, or the due
date of the tax return, whichever is earlier), and
6.
2.) The Replacement property acquired is substantially the same as identified
during the 45-day identification period.
Exchange or Sale
The intent of the delayed property exchange is that you have an actual
continuation of your old property investment into your new replacement
property. To qualify, you must follow the rules and requirements of Section
1031 of the IRS Code. Intent does not count. What you actually do is what
determines if you qualify. Actions taken for the primary purpose of
avoiding tax will usually be disqualified.
For the serious investor that is no problem. You are just rolling your
profit from one property into another that you feel will be a better
investment. Plus, the only time you would ever be challenged is if your
taxes were audited.
Section 1031 requires an actual exchange of properties. If you simply
sell a property and reinvest the money in another property that is not an
exchange. It would be considered “Constructive Receipt”. Constructive
receipt occurs when you have the funds in a position in which you may draw
on them, direct their usage or give notice of intention to withdraw the funds.
You must not have control of any funds involved in an exchange. If you do
you will be considered to have constructive receipt. One of the primary
ways to avoid that is with a written contractual agreement with a neutral
party called an intermediary or facilitator.
You are not in constructive receipt if your control over this money is
subject to a substantial limitation or restriction. You are in constructive
receipt at the time such limitations or restrictions lapse, expire, or are
waived. Additionally you are in constructive receipt if your agent accepts
the money.
It is important to have an intermediary accept and disburse any funds
connected with your exchange. This is called a safe harbor. You must
never, at any point in the transaction, have possession of the money.
Although there is more than one type of safe harbor the only practical
safe harbor for most exchanges is a facilitator or intermediary.
7.
This is a person or company that is in the business of acting as an
intermediary in exchanges.
The other two safe harbor arrangements call for establishing special
trusts or special security and guarantee arrangements, which are quite
complicated. An intermediary, for a fee, acts to facilitate the deferred
exchange by entering into an agreement to exchange the properties.
Under this agreement the intermediary sells the relinquished property,
acquires the replacement property and transfers the replacement property to
the exchanger.
Who may not serve as an intermediary for the exchanger? They
include related parties such as a spouse, ancestors, descendants, siblings or
employees of the exchanger.
Also disqualified are the exchanger’s attorney, accountant, investment
banker, broker, real estate agent, related corporations or trusts where 10% or
more of the stock or ownership is owned directly or indirectly by the
exchanger.
In another words, keep it simple and use a facilitator/intermediary.
The intermediary dos not provide legal or specific tax advice to the
exchanger, but will usually perform the following services:
1.) Coordinate with the exchanger and his advisors, to structure a successful
exchange.
2.) Prepare the documentation for the exchange and replacement properties.
3.) Furnish escrow with instructions to effect the exchange.
4.) Secure the funds in an insured bank account until the exchange is
completed.
5.) Provide the documents to transfer the replacement property to the
exchanger and disburse the exchange proceeds to escrow. This document and accompanying materials are designed to provide authoritative information in regard to the subject matter covered in it. It is for illustration purposes only and presented with the understanding that the author and publisher are not engaged in rendering legal, accounting or other professional opinions. If legal advice or other expert assistance is required, the services of a competent professional should be sought. |
