(1888PressRelease)
July 28, 2007 - Why Do a 1031 Exchange?
By Chuck Salisbury, Author of
The Incredible Investment Book
It seems like we are becoming a country that depends more and more upon the Government to solve our problems even if the government is the source of those problems. Take, for example, the IRS collection of taxes on income, capital gains and estates. Although the tax rates and exemptions change for political exposition, they do not seem to go away. Although the tax rates change depending on whether the gain is short term or long term, most real estate investors deal with the latter. So, when an investor owns property for a period of time and the value of the property increases, they would like to trade it in for different property much like trading cars when the new models look so much better. The problem with selling is the creation of a tax obligation based upon the profits generated over the term of the investor’s ownership. The gain may be greater based upon the length of time and the depreciation schedule used during ownership.
For example, you own this property for 10 years and purchased it originally for $105,000 and used a 27.5 year depreciation schedule. After ten years you have written off (depreciated) about $25,000 from the value of the improvement on the land (the house) and your cost basis is now $80,000. Since it is now worth $250,000 you will have taxes due on the $170,000 as long term capital gain (over 12 months). Your tax advisor suggests that you trade your property through a 1031 exchange and defer the taxes until some future date when you are in a lower tax bracket. This tax deferral tool was introduced by the IRS on April 25, 1991 under regulation-Reg 1.1031(k)-1 and permits you to sell your property now and use the proceeds to purchase replacement property as long as you follow IRS rules, complete the purchase within a specified time period and use the services of a Qualified Intermediary who will insure that you exchange like kind investment property. Although the process is relatively safe if handled by a professional the potential for error is always present and you may end up buying a replacement property that is less than suitable in order to maintain your tax deferred status within the stated time period. The objective is clear and that is to avoid paying taxes now.
I have a better and more productive solution that is actually easier and not subject to the errors of a 1031 mistake. I advise my clients to refinance their appreciated property and use the net proceeds of the new loan to buy whatever they want whenever the right opportunity presents itself. No pressure, no IRS rules to deal with and less possibility of making an error. Most important is the fact that you still own the original property and will continue to enjoy its further growth over the years. Since you did not sell, you do not have any tax to pay. You remain in control and can decide when to refinance and what you are going to buy with the net proceeds. You may choose to refinance to lower your interest rate, extend the maturity date or choose to just get a line of credit secured by your equity. That way you buy more property using the equity from the property that has appreciated. That’s called using OPM and we don’t need to explain that term to any real estate investors.
You continue to depreciate the original property and add more property in order to build your real estate business. So why would you ever do a 1031 exchange? That is truly a fair question. As for me, I see no good reason to do it when you consider the simple option of refinancing and buying more of the best property in the best locations with no more than 10% down. Our website www.TenPercentDown.com is one of the leading websites in America for finding suitable investment homes in growth areas.
I can think of one 1031 exchange that makes some sense and that is to exchange vacant land for income producing property. The reason for my flexibility in this area is based upon the knowledge that you cannot borrow as much or as freely on vacant land as you can on income producing property. Deferring the capital gains on vacant land is also more attractive because your original cost is the basis for figuring your long term capital gains tax. You see, you cannot depreciate land only the improvements on the land. Also, you cannot leverage land in the same way you can leverage income producing property. Income property can be purchased with 10% down but raw land may take a 50% down payment because it is harder to finance. Sometimes the seller will take back some paper but that usually has a shorter maturity date than a 30 year mortgage. So, do a 1031 exchange to move from raw land to income producing property with my blessing. May all your gains be monumental, but tax free.
