Working as an investor in the real estate business has its share of trials and tribulations: how can you manage your business and build the value of your investments while adhering to local and national laws and tax codes? Luckily, those two things are not mutually exclusive: it is entirely possible for smart investors to learn how to use regulations and codes to their advantage. Savvy investors know how to manage tax burdens while working with the system - not against it.
If you’re a real estate investor, you understand that there are plenty of ways to do well in the business – but even more ways to fail. One of the ways that real estate investors commonly find trouble is in the oddities of the American tax code: play the rules just right and you’ll come out on top – but make one slip and you can find yourself with an unbearably heavy tax burden.
This is especially true for investors who are constantly upgrading from one property to another: it’s a widely known fact that the best way to earn money in real estate is to (drumroll, please) regularly purchase properties that are higher and higher up on the value ladder. The trouble, however, is this: say I purchased a property ten years ago at a cost of $100,000. In the time that I have held the property, it has risen in value to $200,000. I’m hoping to grow my investment, and I have an additional $100,000 I would like to spend – so I want to sell my original property and purchase one that is worth $300,000. The catch, though, is that I’m not going to get $200,000 for my $200,000 property: because that property is for investment (rather than a primary residence), I am taxed on my $100,000 appreciation as capital gains tax. Suddenly, I sell that $200,000 property and walk away with only $150,000 – and then how am I going to purchase that $300,000 upgrade I have my eye on?
The catch, then, is taxes: if you’re not careful, taxes can take a big bite out of your real estate earnings. The truth of the matter is that taxes are never going to disappear: nothing we do can make them turn tail and run away yelping. What we can do, however, is learn to manage our tax burdens – and this is where 1031 exchanges come into play. The 1031 tax exchange allows real estate investors to immediately invest accumulated property value into another property without paying capital gains tax in the interim. Will you have to pay that capital gains tax eventually? Absolutely: the 1031 process certainly didn’t make it disappear. What it did do, however, was allow you to work to grow your real estate wealth immediately by deferring your taxes to the time when you choose to exit the real estate business.
Managing a 1031 Exchange
Managing a 1031 exchange is not difficult – but it does require adherence to strict 1031 tax exchange rules and regulations. 1031 exchanges are not appropriate for residential properties (where capital gains taxes are not generally an issue), and there are limits on how often 1031 exchanges can be completed. Additionally, the 1031 exchange process has stringent time deadlines that must be met. For these reasons, you must enter into a 1031 exchange with the advice of a tax professional and the assistance of a qualified intermediary working on your behalf.
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