The journey of the tax code pursuant to IRC section 1031 is striking when viewed against this moment in United States real estate history. Never before have U.S. real estate investors acquired and stood with so much appreciation in real estate in such a short period of time. Never before has the tax code as it relates to section 1031 been so straight forward and simplified for the real estate investor to sell property, recognize gain and roll that gain into a new property without the tax bite.
What is so special about this point in history that should unleash an unprecedented amount of 1031 exchanges?
When income taxes were first enacted in 1918, Public Law No. 65-25440 stated that loss and gain would be calculated on all sales of property. In 1921, during the 67th Congressional Session Congress enacted section 1031 and it remained relatively unchanged for nearly 60 years. For the sophisticated investor with a slew of tax and accounting professionals on hand, the law was used aggressively with transactions requiring an attorney opinion letter to bless the validity of the transaction and allow the tax payer to defer taxes on the sale. This allows substantial advantages to an investor. He can trade up using someone else’s money (the bank’s) and he can shelter taxes due by deferring them on an ongoing basis using section 1031.
By sheltering the gain and deferring all state and federal taxes he is able to unlock the biggest impediment to a high rate of return: excess equity. Prior to 1990, regulations were complex in the tax code concerning many of the surrounding 1031 exchanges that to be safe you needed an attorney opinion letter.
The grey issues subsided and the cloak and dagger obscurity changed dramatically with the Omnibus Budget Act of 1990. Since 1996, we have experienced the greatest increase in property values in many major real estate markets across the nation. In many cases property values have doubled since 1995 and in some cases only in the past three years. When these properties are transferred, they will account for some of the largest capital gains to be created in the history of the real estate market.
Although it remains a Federal Law, it is virtually unknown amongst investors. The simplifications to the law have combined with the great appreciation in real estate since the bottom of the real estate recession in 1997 to create unprecedented exchange opportunities.
Let’s look at a few examples of where section 1031 can make a difference.
1| As a tool to grow a portfolio of real estate: An investment property which has increased about $200,000 in value would be subject to capital gains tax of about $56,000.00 based on a tax rate of 28 percent. By using section 1031 the $56,000.00 can be saved for investment in a replacement property.
2| As a way to turn your gain into tax free cash while leveraging your real estate assets: Once a property has been sold and a new one purchased to replace it, then the replacement property can be refinanced and cash taken out as loan proceeds Which are not taxed as income- instead of capital gain which is taxable. That is, one can exchange a property and not pay capital gains but still obtain access to equity by refinancing and taking cash out.
To accomplish this you must:
- Identify a property and enter into a contract to sell.
- Contract with a 1031 exchange accommodator.
- Close on a replacement property.
After closing, refinance the subject replacement property and pull out equity. (The court cases favor this approach as opposed to refinancing your portfolio sale property and then accomplishing the 1031)
3| As an estate planning tool, integrated with a financial plan: A useful strategy for families to pass their real estate holdings on is to have the real estate deeded into a family partnership or LLC (limited liability company). The parent who has acquired the real estate is able to continue to take management income from the property but the heirs receive the property without taxation and can continue to 1031 exchange the property and grow a real estate portfolio.
The Fundamental Issue
We know at this point that we are at a time when 1031 exchanges are simpler and cleaner than ever before in the past 60 years. The fundamental issue that exists is not the law but how people will use this newly simplified legal environment to create a real estate investment plan and grow their portfolios. The answer is to use section 1031 as a tool to continue selling and exchanging properties tax deferred, which can continue to grow on for heirs who need not be burdened with taxation and can invest more of their proceeds into real estate.
The basis of any financial plan is thought and actions well executed. The time is right for all investors to start to make a financial plan using 1031 tools available.