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Why the Section 1031 Exchange Might be a Hidden Gold Mine for Real Estate Investors

There are a couple of distinct tax advantages for real estate investors.

As the economy continues to show signs of improvement, with the stock market breaking all sorts of records and unemployment falling steadily, it is only reasonable to expect, all thing being equal, that the real estate market will also make significantly upward strides, and will once again become a very viable investment vehicle.

People invest in real estate for a variety of reasons, the two main ones being the following:

  1. Capital appreciation: This is when the property increases in value over time. This appreciation may be due to either a general change in the real estate market in a particular locality, or to an increase in demand for property in a particular area, due to changes in the demographics of the locality.
  2. Net cash inflows from rental income: This type of investment consists mainly of buying a property, such as apartment buildings or single or multi-family houses, and operating these units in a way to collect a net inflow of cash in the form of rental income.

If capital appreciation is your main objective, then you would expect to make a profit if you sell your investment property. This profit, if realized, is called a capital gain, and you will generally have to pay capital gains tax when you file your taxes for the year of sale.

The IRC Section 1031 exchange, however, provides an exception to this rule and allows you to postpone (defer) paying tax on the gain if you reinvest the total proceeds from the sale of the property in question, in similar property. This is called a qualifying like-kind exchange. Capital gains tax rates are relatively low, but by doing a Section 1031 exchange, also called a like-kind or tax-deferred exchange, you can avoid them altogether.

This tax deferred, which is really the government’s money that you don’t have to pay over to them immediately, could be used over time to increase your real estate holdings or other investments, and could potentially place you on a path for exponential growth.

In order to defer capital gains using the Section 1031 exchange, there are, however, several stringent requirements that must be met, the main ones are listed below:

  • The property must be exchanged for a like-kind property, and must have been used for investment, trade or business.
  • Within 45 days of the property being sold, the replacement property must be identified, and must be actually purchased within 180 days.
  • All sales proceeds from the property being sold must be held by an intermediary and cannot go to the seller
  • The equity from the relinquished property must be reinvested in a replacement property of equal or greater value to the property being sold.

One should note, however, that gains deferred in a like-kind exchange under Section 1031 are only tax-deferred as long as you keep taking advantage of the provision; they are not perpetually tax-free.

In addition to the Section 1031 tax benefits, there are a number of other distinct tax advantages to be derived from investing in real estate, which include the following:

  • You can claim a deduction for depreciation. Depreciation is the process by which you are allowed to deduct the cost of buying or improving your rental property, from the rental income you receive. Depreciation spreads those costs over the useful life of the property, and can substantially reduce your taxable rental income each year.
  • You can enjoy the lower capital gains tax rate. The profit you make from selling your investment property is called a capital gain. A long-term capital gain is taxed at a lower rate than ordinary income.
  • You are entitled to deduction from your rental income, all finance, and other operating costs.
  • You may be entitled to deduct some of your real estate losses from your other income. Rental activities are considered passive activities, and the general rule is that you cannot offset your real estate losses against your other (non-passive) income. Tax law, however, allows an exception to the passive activities rule under certain conditions, and you may be allowed to deduct some of your (passive) real estate losses, from your other income.

With all that being said - good investing, my friends.

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