Category: Business Strategies
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Posted on: 11/10/2008
Posted by: RiyahsDream12
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How to Avoid Taxes on the
We should begin by clearing up two misconceptions about getting out of one investment property and into another without paying taxes on your profits.
First of all, the title to this chapter is really incorrect. You cannot “avoid” paying taxes. You are merely “deferring” taxes. Sooner or later, IRS will probably still get their share. I say ‘probably’ because a little later in that chapter, we’ll suggest a way that you can really avoid paying capital gains tax on your profit.
The second misconception is that, like your home, you can sell your investment real estate property and avoid paying taxes by purchasing another one.
This rule does not hold true for real estate held for investment purposes. The rules have been relaxed in the past few years when the 1031 exchange rule was revised. The old 1031 rule allowed you to exchange (not sell) your present property in trade for another provided:
1. The property you were acquiring was of greater value than the one you were getting out of.
2. The greater value meant you could not take any cash out of the exchange, you had to acquire a mortgage as large or larger than the one you were getting out of (referred to as ‘net loan relief’, and you could not take anything else in lieu of cash, such as a car, boat, stocks, etc.
3. The exchange had to be simultaneous. In other words, you had to acquire the new property at the same time you traded out of the present one.
As you can guess, tax deferred exchanges were very difficult to structure. In 1984, the IRS relaxed the rules to make them easier to understand and easier to create a tax free exchange.
According to tax code 1031a3A as amended by the 1984 code section 77a, you can now sell your property provided you:
1. Identify the property you intend to “buy” in the exchange within 45 days of the closing on your property, and
2. Close on the second property within 180 days of the previous closing or by the due date of your taxes in the year of the sale of your property, whichever occurs first.
3. You still have to qualify for the tests outlined earlier: The property you are acquiring is large than the one you are giving.
You will receive no “net loan relief.” You are actually acquiring additional indebtedness.
You received no cash or “boot” in the transaction. “Boot” would be something of value in lieu of cash, such as a car or boat.
It sounds complicated but well worth the effort.
Tip: You need to consult your tax counsel if you intend to create a tax deferred exchange.
How Long Can You Defer Taxes?
As long as you keep exchanging from one property to another, and following the 1031 exchange rules, you can defer paying capital gains tax on your profit indefinitely.
What About Never Paying Tax I Mentioned?
According to present tax laws, when you die, your heirs will inherit your property at current market value and not at your original basis in the property.
What exactly does this mean? Suppose you purchase the $105,000 house and resell it at a $30,000 profit under 1031 tax rules. You do not have to pay taxes on that $30,000.
There is actually a little more to it than that. If you hold onto the house for a few years, you will probably take the depreciation benefits allowed by law to reduce your taxable income.
This depreciation amount is recaptured when you sell the property. In other words, you have to add that into the profit you made on the sale, so your taxable profit would be more than $30,000.
Instead, you exchange into the $290,000 property we used in the example in Chapter #19, When You Should Sell and Why.
During the next 25 years, you continue the same process, exchanging from one property to a larger one whenever you equity is double your original equity when you bought the current property. You now own a real estate property worth $1,000,000. Your equity had grown from the original
Nothing Down amount to about a quarter of a million dollars. When you die, you heirs will inherit the property at the current $1,000,000 value and other than inheritance tax on your estate (depending on how your will is set up), they have avoided paying capital gains tax on all the profit you made over the years.
Important: Again, work out full details with your tax counsel to insure you follow the rules, and be sure they have not changed.
In the chapter on financing, we mentioned that you can refinance an existing investment property and take cash out of it tax free. IRS says you are just borrowing your own money in exchange for a mortgage, so it is not taxable…or something like that.
Why would you want to increase the debt on a property you already own and is very profitable. Increasing the mortgage will reduce your cash flow on the property won’t it?
Yes, it will reduce the dollar amount of profit the property produces, but it will also reduce the equity you have in the property so the proportion between cash flow and equity could and should remain about the same. It the property was giving you a nine percent return on cash invested originally, it still should give you a nine percent cash return on your new equity after refinancing.
The advantage is you are again making better use of leverage to create wealth. Remember the rule that when your equity is double what you originally invested, it is time to make an adjustment. Well, refinancing is the other alternative to exchanging into a larger property.
There is another advantage to refinancing and using the cash to buy another investment property. Your real estate assets are now divided between to properties. All of you money is not tied up in only one property.
There is a disadvantage to doing this, however. Usually a larger property is easier to manage and the expenses on a per unit basis are less than on two smaller properties. You have to weigh the choices and see which alternative is best for you.
Caution: Always prepare a financial analysis on each property before you make a decision to change. If you feel I keep reminding you of that quite often, you’re right. It is probably the most important few minutes you will spend in your entire investment program. It is the best way to reasonably insure you are making a sound investment decision.
Included with our investment course is a program that lets you plug in a few figures, click a calculate button and it will determine if it makes sense to refinance an existing property and how much you must earn on that money to have it pay off doing it in the first place. It also gives you an estimate of what your property is worth today.
This brings up an interesting point. Don’t be guilty of the mistake many investors make when they are not aware of how to make the most of their real estate investments.
Suppose you have owned your property for five years. When you purchased it, you had $30,000 cash equity invested and the property was giving you a ten percent return on your invested capital or $3,000. Now, five years later, you have a cash flow of about $4,000 due to annual increases in the rent you are charging your tenants.
Your first thought may be, I’m now earning over 13% on my $30,000 investment. ($3,000 divided by $30,000) Why would I want to do anything?
I hope, by now, you already know the answer to that question. In a previous example we showed how, with a minimum amount of annual appreciation of four percent per year, your equity in the property is now about $60,000.
Your actual return on your $4,000 cash flow is only 6.7% ($4,000 divided by $60,000) and each year it will continue to drop as your equity continues to increase.
You have lost the primary wealth building potential of your investment.
How does this happen…in case you really want to know. We estimated a four percent annual appreciation rate, which means our cash flow will increase about four percent per year, but so will the market value of our property. Four percent on a $130,000 property is a lot larger amount than four percent on $3,000. At the same time, thanks to our tenants, our mortgage is also being paid down, so we now owe less on the property, which also increases our equity.
If, of course, you immediately flipped the property for a profit right after you purchased, this whole lecture did not apply to you. Sorry, but maybe next time.