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How to buy your next investment property with the Government's money.
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If you’re in the market for a new investment property, why not let Uncle Sam help you pay for it? Sounds too good to be true, right? Well, by taking advantage of the 1031 exchange (also known as the like-kind exchange) when you buy and sell investment properties, you can literally get a little help from the government on your next purchase. This little-known tax provision allows taxpayers to legally defer paying taxes on capital gains from investment property sales when they use the money to purchase another investment property.
According to the experts, when you sell an investment property that has
increased in value, such as a vacation rental or commercial building,
the proceeds include the basis, which is the amount you paid for the
property; the capital gains, which is the profit from the increase in
property value; and taxes, the government’s share of your profits from
capital gains. Now, if you intend to reinvest in a new piece of rental
property, the tax deferred exchange allows you to reinvest the amount
that otherwise has to be paid in taxes.
For example, say you paid $100,000 for a villa on Hilton Head fifteen
years ago, and now you’re in a contract to sell it for $500,000. That’s
a capital gain of $400,000. Taxed at 15percent, you owe Uncle Sam
$60,000. But if you take advantage of the 1031 exchange, and follow the
rules for doing so, you can use your $60,000 to purchase another
investment property – a commercial building in Bluffton, for example.
The key to this tax deferral is you have to relinquish one property and
purchase a replacement investment property within a specified number of
days following a specific set of guidelines; otherwise the IRS will
come knocking. Here’s how it works. According to the experts, at some
point, between the time you contract to sell the relinquished property
and the time you close the sale, you must enter into a written
agreement with a qualified intermediary who will hold on to your sales
proceeds until you contract to buy a replacement property. From the day
you close the sale on your relinquished property, you have forty-five
days to identify potential replacement properties. And within one
hundred-eighty days after closing, you must close on a replacement
property. Your qualified intermediary will provide the proceeds held on
your behalf to purchase the replacement property.
Here’s another bonus – if you hang on to that replacement property, or
continue to roll the capital gains into new investment properties using
the tax deferred exchange, your heirs will get a stepped-up basis in
whatever investment property you own at the time of your death. So when
they decide to sell the property, their capital gain taxes will be
based on the selling price minus the property value at the time of your
death, not the amount you originally paid for the property. In other
words, you effectively cheat Uncle Sam out of a hefty chunk of his
capital gains tax money.
So what’s the catch? There’s a few. First, the rule only applies to
“like-kind” properties. According to the experts, in the real estate
world, “like-kind” can be liberally construed. As long as the
properties involved are investment properties, or properties held for
productive use in business or trade, you can take advantage of the 1031
exchange. Your personal residence does not apply, and neither do second
homes that aren’t rented out.
Second, you have to follow all the rules. And the rules aren’t simple.
So if you’re thinking about taking advantage of the 1031 exchange, make
sure you consult with a real estate attorney to draft the documents and
provide guidance throughout the process. When you take advantage of the
1031 exchange for your next investment property transaction, you can
keep your checkbook closed next April – well, at least when it comes to
capital gains.
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