The IRS Section 1031 exchange is a real estate investor’s best tool for avoiding (deferring) capital gains on the sale of real property. In a nutshell, the strategy is to sell one piece of appreciated real estate (it can be a house, condo, raw land, or commercial building or multifamily property, as long as it was held for investment and is in the U.S.), and when selling, exchange the proceeds into up to three potential target properties.
An example would be: You have a home in Greenlake that you bought back in ’88 for $88,000. After you moved out to the ‘burbs in Lake Forest Park, you kept the house and rented it out. Now it’s worth $488,000, but it’s only renting for $1300. Your most excellent RPA agent thinks you can buy a fourplex for that much, and get twice the rent.
So you put the bungalow on the market, and it sells in three days (hot market). You get $500,000. The 1031 rules require that you identify potential “replacement” properties within 45 days of closing on the “relinquished” property….so you still have some time, but since your closing on the bungalow is in 30 days…you only have 2.5 months. After closing, in 30 days, you’ll have a total of six months to close the target property.
You make the offer on the Shoreline fourplex, subject to the closing of the bungalow. Bungalow closes. A few weeks later, you close the fourplex. Cashflow doubles. And here’s the tax advantage: If you had just taken the proceeds out of the bungalow, you would have paid capital gains on $500,000, minus the closing costs (commissions, excise, title), minus your $88,000 basis (and less depreciation on that basis). Let’s say that was $460,000 net sales price, minus $88,000 = $372,000 in gain. You would likely pay 15% in capital gains taxes, plus Obamacare of about 3%. 18% of $372,000 is a tax bill of $67,000. But you don’t have to pay that tax now. The 1031 allows you to exchange your low basis into the new property (and if you buy something more expensive, the basis increases by that difference). You can do this again and again….fourplex into 10 unit building. Three houses into a commercial office building. Vacant land into a rental house in Palm Springs. You can keep shuffling as long as you follow the rules. And if you play long enough…you will never pay the gain. Your estate will take over those properties at their stepped up basis (subject to estate tax limitations).
There is a cost. Our preferred “exchange facilitator” is this guy: http://1031exchange.net/craig.asp. Craig just completed an exchange for a long time client, who sold her former home in Bellevue and bought a triplex in Ballard. His total fee was $1,000 to handle the funds and complete both ends of that exchange.
We do these for clients all the time, successfully. There are innumerable permutations — you can pull cash out for example, and step down in value (you pay tax on that “boot” which you pull out). Please call … we can help you get better cards.