When you go to sell your appreciated property, it would be a real waste to give away much of your hard earned equity because of capital gains taxes. A 1031 exchange appeals to only one kind of investor: The investor who wants a better investment without getting socked with unnecessary capital gains taxes!
Lets face it, real estate is an incredibly versatile investment. You can rent it, improve it, leverage it, cash out—you name it, someone has probably done it. But not all real estate is created equal. At some point you may want to cash in on your equity in a piece of investment property without actually getting out of real estate. By re-investing your equity from your old investment property into a new like-kind property, you can use a 1031 exchange to defer the taxes.
Why defer taxes?
Let’s start out with why you would want to defer taxes in the first place. Some investors might be thinking, “If I have to pay them, I may as well pay them now and get it over with.” Not necessarily!
Suppose you have a duplex rental unit across town. A four-plex down the street goes up for sale. You could sell your duplex, pay the capital gains tax, and then buy the four-plex down the street. But using a 1031 exchange will roll your profits into your next real estate property without the tax bite. The tax is not forgiven, just deferred indefinitely—but you conserved your equity by not having to pay taxes on your net profits. Buying the four-plex keeps your money working for you, which compounds and builds your wealth faster over time.
Another reason to defer tax is that there may well be a better time to pay tax. An important principle in tax planning is to defer taxes when you have a high income and pay taxes when you have a lower income. One popular strategy is to cash out after you retire when you are in a lower tax bracket.
A third reason to defer tax is to manage your estate planning. With appropriate estate planning, you can simply keep exchanging properties, which will defer the taxes on the gains indefinitely. Meanwhile, the properties can continue to generate income. Let your heirs worry about the tax on the gains! Defer, defer and die. Under the current tax rules, your heirs will get to “step up” the basis in the property, effectively wiping out the deferred tax liability that you carried with you thought your life. This step up in basis law may be changed in 2010.
Finally, the age-old important and fundamental principle of the “time value of money” tells us that that a dollar in your pocket today is worth more than a dollar you will receive tomorrow. That is because if you have a dollar today, you can use it today—you can invest it, build more wealth with it, which means tomorrow you will have your dollar plus a day’s growth or interest. That’s not a lot if we’re talking about an actual dollar, but it’s a lot if we’re talking about, say, a small apartment building you’ve owned for a few years.
Suppose that if you sell that apartment building, you would realize a tax liability of $100,000. If you were to roll that $100,000 into an investment that appreciated 4.5% annually (a pretty conservative rate of appreciation), at the end of three years, the $100,000 would be worth $114,117. The $100,000 today has a future value of $114,117. So what is the future value of $100,000 today? Asked another way, how much do you have to invest today at 4.5% to have $100,000 in three years? About $87,630. If you had the choice today between $87,630 and $100,000, you would choose the $100,000. If you had the choice three years from now between $100,000 and $114,117, you would choose the $114,117.
In other words, you would choose to preserve the entire gain on that apartment building.
Is a 1031 right for me?
As I said, a 1031 exchange is right only for the investor who wants a better investment. Now let’s look at a few examples.
Suppose you have a parcel of raw land. It’s doing nothing for you—just sitting there, not producing any income. You might want to exchange this property for another property, one that would provide you with some cash flow and deductions (such as depreciation).
Suppose you own a property whose appreciation has leveled off. Maybe you own some rental housing in a once-hot, now-cold neighborhood. You can do a 1031 exchange to acquire a property whose value will continue to grow.
Suppose you own a management-intensive commercial property that is becoming more trouble than it is worth. Use a 1031 exchange to shed the headaches and obtain a more worry-free property.
Executing a 1031 exchange requires faithful adherence to the IRC regulations. You want to work with a company that fully understands the parameters and deadlines of the regulation. Commercial Partners Exchange Company specializes in the 1031 exchange. We offer Qualified Intermediary services and can help you determine if a 1031 exchange is right for you.
Jeff Peterson is President of Commercial Partners Exchange Company. His company is a facilitator of standard deferred 1031 exchanges, build-to-suit construction improvement exchanges, reverse exchanges and aircraft personal property exchanges. Mr. Peterson is an adjunct professor at William Mitchell College of Law and a frequent speaker and CLE presenter throughout the Midwest for various business and professional organizations on numerous issues related to 1031 exchanges. Jeff can be reached at 612-643-1031 firstname.lastname@example.org or check out www.jeffpeterson.name or get more information on 1031 exchanges at www.CPEC1031.com