“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.
Over and over again the Courts have said that there is nothing sinister in arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demand.”
—Judge Learned Hand, Helvering v. Gregory (2d Cir. 1934)
As an owner of commercial /investment real estate property, you are well aware of the benefits you are able to enjoy while you own the real estate. Benefits like: Equity Build-up, Capital Appreciation, Passive Income, Depreciation and the non-correlation with the Stock Market
And if you’ve held your Real Estate Investment for a while, the chances are that it has done pretty darn well for you over the years, and now you realized it’s finally time to take your profits & move on. But the actual mechanics of just selling & reinvesting are proving to be a bit confusing if not downright daunting.
It’s not just paying the Capital Gains tax (Federal, State & Local) but then you find out that the depreciation that has been your good friend for all those many years comes back to bite you as Depreciation Recapture Tax.
Seems like what the Tax Man Giveth when you owned the property gets taken away when you Sell!
Heck, between Capital Gains Tax and the Recapture Tax on Depreciation previously taken it’s not uncommon to see a Tax Bill on your Sale of 25%…30%…even 40% or more!
What to do?
Fortunately, since 1921 there exists within our US Tax Code Section 1031 Real Estate Exchange.
Section 1031 allows the Investor to pay the taxes on his sale when he so chooses.
(Now that I’ve got your attention…)
This provision allows you to legally defer ALL the taxes due on the sale of your investment real estate PROVIDING you follow the very strict rules established in the Tax Code.
In a nutshell, you can defer ALL the taxes triggered by your property sale as long as you reinvest all the sales proceeds into another piece of investment real estate of equal or greater value as well as replacing the same or greater amount of debt into the new Replacement Property.
And like anything sanctioned by the government, you have to abide by very strict & unyielding time constraints.
So what’s this all mean?
By taking advantage of Section 1031 of our Tax Code you pay ZERO Capital Gains at the point of Sale. (No Federal, No State, No Local). And you pay ZERO Depreciation Recapture.
So remember the 25%…30%…maybe even up to 40% Tax on the sale of your investment real estate that I was talking about earlier, by using Section 1031 you pay NOTHING…ZERO…NADA when you sell your investment property.
But wait, how can that be? My Mom used to always say “that there isn’t nothing in this world that’s FREE”.
What’s the Catch?
OK. You’ve sold your property & bought a new one & met all the requirements to comply with the Section 1031 Real Estate Exchange. And so far you’ve paid ZERO Tax. When you Sell this newly acquired 1031 Replacement Property down the road you’ll have a couple of decisions to make:
If you Sell & Take the Sales Proceeds, all taxes that you previously deferred come due.
If you Sell & do another 1031 Exchange, you continue to defer all the old taxes on the first sale as well as the new taxes on the current sale.
Now get this: If you still own the Replacement Property and you die, there is a Step-Up in Basis and nobody pays the Taxes!
That’s right! If you die owning the Replacement Property Nobody pays the Tax Man!
Once you start down the 1031 Exchange Road you most likely will want to continue to Sell & Exchange until you Pass on so that all the taxes that you were able to defer never, never, never become due & Payable.
Section 1031 Real Estate Exchanges when executed properly are the Last Great American Tax Shelter.
We now know that by taking advantage of Section 1031 Real Estate Exchange Rules you can Legally & 100% Completely defer all the Taxes on the Sale of your current Investment Property.
The IRS Rules for 1031 Exchanges must be followed by all Investors. THERE ARE NO EXCEPTIONS. If you break one of the 1031 Rules your Exchange is disallowed and you pay Capital Gains & Depreciation Recapture. Game Over.
That being said there are three basic rules that must be followed:
1) From the date you Close on your “relinquished property” (the property that you are selling and deferring the taxes on), you have 45 Days to identify the property or properties that you wish to Exchange into. This is known as your 45 Day Identification Period.
2) From the date that you Close on your “relinquished property” you have 180 days to close on the new “replacement property” (the property that you are buying or “exchanging into”.) If you fail to close on your replacement property within the 180 day guideline, you blow your exchange.
3) A Qualified Intermediary must hold the sale proceeds for your 1031 Exchange. If you take possession of the Sales Proceeds, you blow your Exchange and must pay the taxes. You CANNOT HOLD or TOUCH the FUNDs in your 1031.
There are no exceptions to the rules for 1031 Exchange dates and deadlines. The 1031 Clock starts when you Close on your Relinguished Property and moves forward including all Sundays & Holidays. You have to identify the Replacement Property(ies) with your Qualified Intermediary by calendar day 45 from your sale date. You then must close on one or all or the identified properties no later than calendar 180 from the original relinquished property sale date. These 1031 Rules are set in stone and afford zero exceptions.