We can all agree with Ben Franklin when he said, “In this world, nothing is certain except death and taxes.”
Taxes are constant and you’re probably being taxed on the federal level, state level and for a number of other reasons.
Taxes are good for our democracy, but a certain level of taxes is definitely not good for your bottom line if your goal is to build generational wealth with real estate.
Historically, tax breaks and loopholes have been used by all the big corporations and high net worth individuals. But who says you can’t enjoy those same privileges as a mom-and-pop investor?
Enter the star of the moment…the 1031 Exchange!
What exactly is a 1031 exchange?
Just like the 401(k), the 1031 exchange gets its name from the section of the U.S. Internal Revenue Code called, well, Section 1031. It’s not exactly an innovative name, but it serves its purpose well. So well, in fact, that it has become a verb of its own—with people casually telling friends and family to “Section 1031 their properties.”
But that’s about where the similarities between the 1031 exchange and 401(k) stop: their names of origin and to serve as a tax break. A 1031 exchange is much more complex and builds wealth faster than the 401(k) when done right.
In its simplest form, a 1031 exchange allows you to buy and sell investment properties without paying taxes. It serves as a form of tax deferral on the exchange of real estate properties and was established by the government to encourage long-term investment.
If you qualify for the exchange, you can sell a relinquished property and invest all its proceeds into a like-kind replacement property within a certain time. Previously, properties for exchange included artworks, jewelry and similar items. But under the 2017 Tax Cuts and Jobs Act, only real estate property used for business or investment purposes qualify as like-kind property and can be exchanged.
Benefits of the 1031 exchange
The 1031 exchange is a very powerful tool that can help you get to where you need to be financially, so let’s explore the benefits it could give you as a mom-and-pop investor.
1. It reduces tax liabilities through capital gains tax deferral
Imagine selling a property after a long time of remodeling and haggling with prospective buyers only to have up to 40% of the profit taken up by taxes. Yeah, we know the feeling.
Normally, you must recognize any profit from the sale of a property as capital gains and be taxed accordingly. The 1031 exchange counteracts this by preventing you from recognizing such profit as capital gain.
This ensures that capital gains taxes are deferred, so long as you identify and buy a replacement like-kind property within a specified time – more on this shortly.
2. It removes the tax burden of depreciation recapture
Over the years, properties will experience some wear and tear. You’re allowed to mark this as depreciation as it helps to reduce the amount of taxable income on your properties.
However, once you sell the depreciated property, the profit must be reported as ordinary income and will be taxed accordingly. This can quickly become another huge tax liability, especially when you’re selling multiple depreciated properties.
Fortunately, the 1031 exchange allows you to roll the depreciation over into the replacement property.
The tricky thing about this is that if you swap an improved building for unimproved land without a building, you must account for a depreciation recapture since land can’t be depreciated. This is why you need professional help in doing these exchanges so that you maximize your benefits to the fullest.
3. It frees up equity
With no capital gains tax liability or depreciation recapture, you can see just how much equity (cash) you can save for more investment. Additionally, you can use debt (loans or mortgage) to buy replacement property, thereby freeing up more cash.
The mind-blowing aspect of this is that, when done right, you can continue to exchange properties for many years until you’re finally ready to sell them. At that time, it gets taxed just once – at the tax rate for long-term investments which is currently at 15 to 20% depending on your tax bracket.
4. It increases your portfolio
One of the rules of the 1030 exchange is that you can buy as many replacement properties as you like so long as their combined value doesn’t exceed 200% of the value of the relinquished property.
You can also buy up to three replacement properties regardless of their fair market value.
Or you can buy unlimited replacement properties so long as you acquire 95% of the aggregated value of those properties within the exchange period, regardless of their individual valuation.
With this, you can see how exchanging just one property can lead you to own so many more properties. You can then diversify your real estate portfolio by acquiring different kinds of properties such as apartments, malls, or even land.
And all of this can be achieved without any cash leaving your hand when done properly!
5. It can be done with less money and more partners
If you’re just pivoting into real estate, chances are you probably don’t have enough cash to buy a complete apartment building or shopping mall. Or maybe you just don’t want the risk.
You can still qualify for a 1031 exchange with tenancy-in-common (TIC). With TIC, you can buy a property with up to 35 investors and then sell it. Upon selling the property, each of you can conduct an individual 1031 exchange with the section of your proceeds.
6. Properties can be inherited tax-free
If you choose not to sell off your exchanged properties before you die, you and your heirs don’t have to worry about being taxed on all the properties.
Once transferred to your heirs, all deferred taxes are canceled and will be inherited at the fair market value at the time of death.
This is what makes this truly a means of building generational wealth as many properties get to be transferred tax-free down many generations.
Real-life example of how to build significant wealth through a 1031 exchange
Let’s take a look at how savvy mom-and-pop investors use this powerful tool to build wealth in the real world.
Let’s say you had a 20-story apartment building in downtown Los Angeles for 10 years that you bought for $2 million. You own $1 million in equity and have a $1 million mortgage on the property.
You’ve recently found out the building’s worth has doubled over the years, and it is now valued at $4 million. You’ve also paid down 75% of your 15-year mortgage on the property, and you only have $250,000 in debt.
Now let’s say you want to buy a small shopping mall worth $6 million with a $1 million mortgage and you immediately contact your CPA to make an assessment. After talking with your CPA, your CPA advises you to do a 1031 exchange, as both properties qualify.
With the 1031 exchange, you’re able to sell your apartment for $4 million and take a loan of $2 million to acquire the shopping mall. The mall then yields $50,000 in monthly income, and that number will likely continue to grow.
Ready to build generational wealth and reduce tax liabilities?
This example is just one of the many incredible ways mom-and-pop investors are taking advantage of the tax system to build the financially free lives they’ve dreamed of in our area.
The next step is for you to see how you can use this underutilized but powerful tool to expand your real estate portfolio and build generational wealth.
Remember: You can book a free consultation with us to ask any questions you might have about real estate investing in L.A. Send us a note and we’ll help you find success.