In my last blog post, I discussed various tax planning strategies which allow a real estate investor to pay $0 dollars in taxes on their income from their cash flow in real estate. In this post, I will go over the most famous real estate tax strategy which is the quickest way to accumulate vast amounts of wealth: the 1031 exchange. The IRS code allows real estate investors to sell an investment and defer paying any taxes on the profits by rolling the equity of the previous investment into a new deal. This simple tax incentive has been the backbone of countless success stories of investors starting out with renting out a single family home to trading up to a massive apartment community of over 100 units. The catch, you might be wondering, is these capital gains taxes do not just disappear, but rather turn into something called back taxes that follow along with each and every exchange. However, the IRS does a funny thing: If a wise investor has been exchanging up to larger and larger properties throughout his or her life, he or she has most likely accumulated millions of dollars in back taxes. Fortunately, all of these back taxes do in fact disappear when the investor passes away! This is a beautiful, yet morbid, tactic to incorporate in a good estate plan, whereby eliminating the problems associated of paying draconian taxes on your estate when you pass away. An investor’s heirs can take over the investments and keep the snowball of exchanges going, thereby creating massive generational wealth for one’s family.
Another sneaky trick regarding 1031 exchanges is the ability to exchange an investment property into a vacation home. Let’s say you are a successful investor and want to treat your family to a second home in ________ (insert your dream vacation spot here). You can sell an investment property, defer paying any taxes, and purchase a beautiful vacation home in your desired location. You will of course operate this new vacation home as a rental property for at least 14 days per month for the first 24 months of ownership. This rule is under the New Safe Harbor the IRS issued (Proc. 2008-16) in March of 2008. Please speak to your tax specialist before performing any of these tactics, as this is not official legal advice.
Well there you have it! After reading my last two blogs, you have the knowledge and power to never pay a penny in taxes on your income as well as on your profits from selling investments, otherwise known as capital gains.