This week, a client of mine sold a property he'd purchased only one month earlier for $135,000 profit. But he paid no taxes. How? Read below, and see how he saved $40,000.
The Internal Revenue Service has written a rule in its code in Section 1031 that provides a way in which people who sell property (usually, though not necessarily, real estate) can defer the taxes on their profits--indefinitely!
The original way in which taxes were saved was through a swap. For example, you bought a piece of land at the beach for investment for $100,000. Five years later, it's worth $200,000. You'd like to get rid of this land, and buy yourself a duplex. As it so happens, I have a duplex that I bought for $100,000 which I'm willing to sell for $200,000. We work out a deal by which we just swap properties. Although technically, we've each sold property for $100,000 more than we paid (thus usually triggering a tax), Section 1031 lets us defer any gain or taxes because we performed a simultaneous exchange.
Of course, this type of exchange is pretty limited. Usually, if you find someone willing to buy your property at the price you set, they're not going to have a like-kind property you could swap. Section 1031 provides another way to defer taxes called the "non-simultaneous like-kind exchange."
In short, the non-simultaneous exchange (commonly referred to as a "1031 exchange" or "like-kind exchange") allows you to sell your property, put your money into a sort of holding tank (technically called a "qualified intermediary"), find another piece of property you want, take the money out to buy it, and not pay any taxes.
Of course, it's not quite that simple. You've got to pick out the other property (called the "replacement property") within 45 days, and you've got to buy the replacement property within six months after you sold your original property.
Furthermore, the property has to be roughly similar. In other words, you can't sell a piece of land, and do a like-kind exchange with stock or bars of gold. On the other hand, the code doesn't require that the property has to be identical. If you sell a beach lot, you don't have to buy another beach lot--you could replace it with, for example, a duplex.
Back to the original example: let's say a buyer came along willing to pay you $200,000 for your beach lot you bought five years ago for $100,000. To do a like-kind exchange, you'd sell it, and the money would be held by the intermediary. You'd have 45 days to find a replacement property. Let's say after three weeks, you find a rental duplex that you like, which also happens to be roughly the same in value, and sign a contract to purchase. You'd then notify the intermediary, who would provide the money at closing. In this example, not only did you not have to pay taxes on your $100,000 gain, but you converted a non-income-producing property (raw land) into an income-producing property (of course, you'll have to pay income tax on any rentals you receive).
In my real life example, my client purchased a lakefront house and lot for investment at the beginning of August for an excellent price. Last week, he sold it to a buyer for $135,000 more than he'd paid for it.
For the last year, my client had been dickering and negotiating with an individual to buy a 70-acre tract of land my client wanted for investment purposes. They eventually came to an agreement on price. However, my client really didn't want to sink a bunch of cash into the purchase, but he also didn't want to borrow that much money for the land, which would likely sit there for a period of years without earning any income. When I explained the 1031 exchange to him, it was a Godsend. He took the profit from his lake sale, and used it to purchase the acreage he'd wanted. He benefitted in two ways: first, he basically was able to buy the acreage without borrowing money, but also without coming up with any money out of his pocket. Second, he made $135,000 profit, without paying a nickel of taxes--a savings of at least $40,000.
If you're interested in a 1031 exchange for your property, please consult an attorney. If you're interested in discussing it further with me, please contact me by phone at 704-460-7398 or by email at wldeaton@vnet.net.
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