1031: 101 - Tax-Deferred Real Estate Exchanges for Beginners

The sheer number of investment vehicles available to you these days is absolutely staggering. Stocks, bonds, precious metals, commodities, options, derivatives, real estate, etc., etc., etc. - it can make your head spin! Now, all things being equal, none of these investments are better than any other. If you know what you're doing, you can make money in any of them.

However, for the average investor, real estate presents an especially good choice. Most people have some experience with real estate -- usually the purchase of their house -- and it is relatively easy to understand. Real estate is tangible. You can see it, touch it, change it, and use it every day. In addition, real estate can be a good source of cash flow when you rent it. In fact, if you can get a tenant to cover your mortgage, you are in great shape. It's like free equity! Lastly, the taxes on the rents can be offset by your mortgage interest and depreciation -- both of which are great tax deductions against real estate income. And, most importantly, as compared to many investments, you are the one in charge of controlling the future of your investment. Market dynamics affect rents and value, of course.

Yet, making a wise choice in the initial purchase, managing the property well, and selling at the right time can ensure excellent gains.

So, let's say you decide to invest in real estate. You purchase a condominium that you rent to a tenant. Five years later, you decide to sell it and buy a property for your business. Because you made such a good decision on the location of the condo and maintained the unit well, it appreciated in value. Well, if you were to simply sell the condo, the IRS would tax the profits, or "capital gains." The difference between the condo's sales price and what you originally paid for it (plus improvements) will be taxed at 15%. If you took any depreciation over the years, it will have to be "recaptured." Recapture is taxed at 25%. And, there are State and Local taxes to consider, as well. It is not uncommon for an investor to pay the government 30% of their profits. That can be a lot of money! And, there's no reason to pay the government if you don't have to.

But, fear not -- there is a solution called IRC Section 1031. Section 1031 is a provision in the U.S. Tax Code that allows an investor or business-owner to sell their real estate and re-invest the money in another piece of property without paying taxes.

(Actually, these taxes are postponed, or "deferred," until you decide to cash-out of your real estate portfolio or not do another exchange).

Exchanges are easy! The first step to completing an exchange is to contact a "Qualified Intermediary" (or "QI") to handle your exchange. At the closing of the Old Property, the QI will hold the cash proceeds from that sale in trust on your behalf. The funds should be held in a separate bank account and not commingled with other client funds held by the QI. Then, when you direct him to do so, the QI will send those funds to the purchase of the New Property. There are a few simple rules and time deadlines that you will have to keep in mind throughout the exchange to properly defer all of the taxes. For instance, the New Property will have to be equal to or greater in value to the Old Property, you cannot pull any cash out of the closing of the Old Property, and others. Your QI should be able to walk you through the rules. And, that's pretty much it!

Real Estate empires have been created in this manner. The investor buys a small rental or piece of land, and parlays this modest purchase into bigger and bigger real estate investments. The best way to create this empire is to defer taxes by utilizing 1031 Exchanges.