According to Forbes, 10% of all billionaire’s fortunes were built in real estate. Additionally, one of the ways the uber-rich built their fortunes is by knowing tax loopholes.
As of 2018, capital gains taxes fly as high as 37%. To get around that, just like the big real estate ballers, investors use the capital gains loophole to actually defer taxes.
However, many Americans fail to take advantage of these same tax hacks that could lower their tax bills dramatically. Here’s one of the most popular tax hacks used by the 1%.
The 1031 Exchange
One of the secrets to real estate investment is a little-known (outside of real estate) trick; the “1031 Exchange,” which allows you to defer all your capital gains taxes on your recent real estate score.
These exchanges are named after section 1031 of the Internal Revenue Code. By taking advantage of this loophole, investors can reap big breaks on appreciated real estate assets.
5 Fast Facts about the 1031 Exchange:
-The 1031 exchange allows investors to defer capital gains taxes when selling a property
-You have to have held the property for at least a year (so you can’t use this when flipping properties)
-The investor gets to defer the tax bill as long as the money from the sale is used to reinvest in a “replacement property” of equal or greater value
-You have 45 days to identify a replacement property and another 135 days to close. The process can be repeated over and over again
How Investors Use 1031 Exchanges
“Astute investors use 1031 exchanges to diversify their portfolios, exchanging one high priced property for several smaller properties,” tax expert and EVP of Madison 1031 Michael Brady told me a few years ago, “or investing their money in regions where bargains are easier to find.”
Use of these exchanges has been increasing among professional real estate buyers. Annual real estate transaction volume ranges anywhere from $400 billion and $500 billion—and according to Forbes, 30% of that comes from 1031 exchanges.
Let’s assume you bought a property for $1 million three years ago. You fixed it up, pushed up the rents, and now decide you want to sell for $3 million, with only $800,000 in debt on it.
You found a buyer close for $2.85 million—close to the $3 million price tag you were looking for. Boom. You’re ready to cash out. But you still have to pay taxes on your substantial capital gains. Which, in this case, comes out to $2 million– $2.85 million minus the $850,000 mortgage.
However, you want to continue to invest and compound this equity, tax-free. You can take advantage of a 1031 exchange to pick up the “replacement property.”
When you sell a property, you have to meet certain requirements. The most important one being that you have to buy a property of the same $2.85 million or higher. In other words, you can’t just put the $850,000 portion of the proceeds toward a smaller deal, pocket $1.15 million tax-free and go ball out in the Bahamas. You still have to go find the “replacement property.”
Outside of that one limitation, the 1031 exchange has tons of flexibility. For one, you don’t have to match the debt amount on the last mortgage; that’s irrelevant.
Secondly, you’re not required to structure the equity (down payment) in any sort of way. You just have to buy something at a price tag at, or higher than, what you sold it at.
You can even split the $2 million into one or more replacement properties—worth the same or more—than where you want to defer the money to. From there, the taxes from the profits made from the first property can be “deferred” and used for your next real estate deal.
Here’s the coolest thing: This process can be repeated as much as you want, as many times as you want, until you either die, or decide you don’t want to invest anymore.
—Disclaimer: The opinions and financial advice expressed in this article are solely those of the contributor’s and not Black Enterprise’s.