“My accountant told me to just pay the tax…….”

We hear this troubling refrain too often.  It seems that many accountants and attorneys will tell their clients that a Section 1031 exchange is cumbersome and just delaying the inevitable. Some advise that the tax rates today are the cheapest you will ever see, “It’s easier to just pay the tax” they say.  In far too many cases, this is terrible advice and costs their clients dearly.

What many investors (and sadly, their advisors) don’t realize is that the capital gains rates upon selling their real estate holdings is not “just 15%”. On January 1, 2013 Uncle Sam rang in the New Year with a capital gains rate increase to 20% for high wage earners, with an additional tax of 3.8% added into the mix to fund the President’s health care initiatives.  Your state also wants their slice to the tune of as high as 13.3% depending on where you call home. Oh, and don’t forget you still have depreciation recapture which gets you for 25% of the depreciation off the top. Didn’t take depreciation? Doesn’t matter, the IRS will figure out what you should have taken then zap you for 25% of that number.

Now that you have run your numbers (and picked your jaw up off the floor) you may see things in a different light.  It is so important to make sure you to understand the ramifications of your sale BEFORE your sale. Unless you have offsetting losses, you might be very surprised at the check you will have to write to the IRS. Section 1031 has some strict time requirements, so the time to start considering 1031 is not 3 days before your closing. If you have already closed, it’s too late.

As the word Exchange implies, you must purchase replacement property so the next step is to understand what your replacement options are. This is where things typically get a little confusing for our clients.  The often repeated myth says that a “like-kind” exchange is just that, exchanging an office building or condo into another office building or condo. Believing this definition causes many real estate investors to dismiss the utility of 1031 because they just don’t want to own another three family apartment building, or another strip mall renting to Joe’s Pizza and FiFi’s Pet shop.

The reality is that you can exchange anything that is classified as real estate for anything that is classified real estate in the 50 US states. That means you can exchange the raw land you have been holding for years in Rhode Island for rental property on the Cape. Or, you can exchange your current office for a condo in Ft. Myers, rent it for a couple of years and then convert it to your personal residence or vacation home without triggering tax!

The following is a real-world example from our files:

Our client was a dentist in Boston who had been practicing for years in a 1600 square foot office condo that he owned. When the time came to relocate his practice to Maine and bring his son on board, he was blown away at the amount of capital gains tax he was responsible for upon the sale.

 Luckily, this dentist had an attorney that had worked with us before and suggested he give our office a call.  As it turns out, this dentist wanted to build a new office building for his practice, and already had plans for a new 6,000 square foot building.

 He used a little known exchange strategy called a Build-to-Suit or Improvement Exchange whereby we set up a special purpose entity for him, purchased the land and built the building. When the building was complete, he sold his Boston property and exchanged into the new building. The numbers where almost identical and he completed the exchange and paid zero capital gains (FED / STATE / Depreciation recapture). What is eye opening about this transaction is that he was planning to sell his building, pay his taxes (over $340,000) and THEN build his new building.  He won, as do most all of our clients.

One of the important aspects of the exchange process is to not only understand 1031 and the rules, but to understand the options that you have using proceeds from an exchange. Not only do first time clients often misunderstand the code or the process, they also don’t understand how it is possible to turn real estate into an income producing vehicle while paying zero capital gains tax.

Section 1031 is one of the few remaining tools provided by the Government that favors the real estate investor. Our company has been facilitating Section 1031 exchanges for over 30 years. Many of our clients are not professional real estate investors and initially don’t fully understand Section 1031 and its many uses. Please call or drop us a line, we love to answer questions and spread the word about the power of Section 1031.

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