
Capital Gains with Passive Incomes
Before we talk about the 1031 exchange rules we need a bit of context. The concept of capital gains remains a debatable topic among many Americans due to the taxes involved. We say that capital gain is selling an asset for a profit. For example, if you buy and hold a rental property for resale at a higher price, the IRS considers that as taxable income and is subject to tax deductions. However, the asset is not subject to tax during the holding period.
Passive income is a great strategy that many investors use to buy and hold assets for prolonged periods for slow but steady wealth creation. It is a good choice as you do not incur the periodic fees of buying and selling as in active investments. For maximum passive income, many investors opt for the 1031 property exchange.
What is an Exchange?
Unlike the literal meaning of the word exchange, it does not mean a swap of properties. At times, it can only be one party conducting the exchange. On the other hand, it is a transaction for the other party, only that it does not involve the exchange of money.
Like-kind in exchange does not imply an apartment for an apartment. Instead, it means an exchange that involves investment or business property. With this understanding, let us now define the 1031 property exchange.
What is 1031 Property Exchange?
1031 is a US tax code from the IRS that explains exhaustively deferred tax on capital gains. That said, the 1031 property exchange is a revenue act that allows a passive investor to defer taxes on capital gains to fund other like-kind investments. A little history will give you a clear understanding of how far this act has come.
The revenue act began in 1918 when taxes helped the US finance World War I. However, at this stage, there was no provision for 1031 property exchange. In 1921, congress enacted the 1031 exchange, which included transferring different assets, including non-like-kind properties. The clause was quickly amended in 1924, prohibiting the exchange of non-like-kind properties while maintaining like-kind interactions.
What is 1031 Starker Exchange?
In 1970, Starker filed a case against the US that marked the beginning of deferred taxes on capital gains. In 1967, the Starker family entered a contract with Crown Zellerbach Corporation on an exchange of over 1800 acres in Oregon. However, Crown did not have an exchange at that point. They agreed that Crown would keep an account for the Starkers until they found a suitable exchange.
Crown later found an exchange within five years, and they agreed to add a 6% growth factor to Starkers’ balance. Upon completion of the exchange, the Starkers’ received more in the market value than the sold item and filed zero capital gains tax. The Starkers’ argued for non-recognition of a property’s gain or loss after an exchange of like-kind property for the same use, investment or business.
The IRS charged the Starkers over $335,000 in taxes, which they paid but filed a claim for a refund. According to the Supreme Court judgement on the case, the Starkers did nothing wrong, as no rules were spelt out in the 1031 exchange. This ruling began a tax deferred exchange popularly called the ‘Starker exchange’. After this case, the IRS changed to include property identification and deadlines for like-kind in the 1031 starker exchange.
Why Are 1031 Exchange Rules Important?
The 1031 exchange rules keep changing over the years. For example, before 1989, a passive investor would make a deferred tax on exchanges of like-kind domestic and foreign properties. However, the Revenue Reconciliation Act of 1989 limited the exchanges to apply only within the US. In January 2018, the Tax Cuts and Jobs Act (TCJA) became law, meaning that only tangible assets are applicable for 1031. It implies that real estate is the only form of asset that you can reap the 1031 benefits. Knowledge of what is applicable will help you remain on the safe side of the law and accrue the attached benefits of this act.
The main advantage of understanding the exchange rules is tax deferment. If you opted out of 1031 before selling a property, your proceeds would attract capital gains tax. However, if you continue with 1031, your properties will be handed down to your heirs at current value upon death. Moreover, 1031 shields your property from depreciation recapture and thus an excellent way to create generational wealth.
1031 allows you to create a nice passive cash flow buildup. Instead of looking for another asset after liquidation, 1031 ensures that you find a replacement immediately and continue making an extra income.
Capital Gains with Commercial Multifamily
Commercial multifamily investments are a profitable way of making passive incomes. However, the initial capital is way too high for individual investors prompting many to use real estate syndication. A syndicate works so that many investors pool resources together to buy commercial multifamily. In this model, the syndicator bears the burden of being the landlord and property management. However, the tax management task still lies with the individual investors.
Many investors enjoy no tax on capital gains with 1031 when investing in commercial multifamily. Nonetheless, at one point in time, you will have to pay the taxes as it is different from a tax relief. There are a few rules that allow one to benefit from 1031, which include:
• Identify the property before the lapse of 45 days
• The new property must be of nearly the same value as the original one
• The exchange must happen within 180 days
There are many syndication benefits in commercial multifamily investments. The most notable being less upfront capital and lesser risk from the investment. It also allows novice and seasoned investors to make deals they couldn’t get on their own. The many units involved enable the syndicate to enjoy economies of scale, translating to more benefits for the investors. An experienced syndicator can help investors reap substantial profits from the venture.
Conclusion
Capital gains of commercial multifamily units are one of the best ways to create wealth. No wonder most of the Forbes top 400 use the 1031 exchange provision in multifamily investments to protect their wealth. However, before you opt for 1031, you must look for an experienced tax expert as the exchange rules can be complicated and confusing for many. If you’re interested in reading it Cornell Law School has it up on their website.
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