There's no secret that the United States Internal Revenue Code favors those who invest in real estate. The government gives incentives to those who are able to provide housing to citizens because it's a job that the government itself struggles to do. Some of those incentives includes write offs, depreciation and capital gains deferral to name a few.
So there's no surprise that 90% of millionaires have made their fortune in real estate. Many of them using a tax loop hole known as the 1031 Exchange.
Under Section 1031 of the United States Internal Revenue Code, an investor can defer paying capital gains and federal income tax on the sale of an investment property if they are exchanging one investment property for another.
Let's walk through an example.
Purchasing Your Rental
Let's say you want to buy your first rental property and you need a loan for $300,000. You take out a second mortgage to purchase the home. (If you currently have a mortgage, a second mortgage is ideal because it will allow you to put down only 10% as opposed to 20% for investment properties).
Let's say you spent $40,000 on down payment and closing cost for the loan.
You immediately put a tenant into the new rental home that will pay you market rate rent which will cover your mortgage payment plus an extra $350 each month. You're now cash flowing $350 each month from your investment.
After a few years, real estate investing starts to look more an more appealing as your tenant continues to pay your mortgage down while padding your pockets with extra cash each month. Now, your sights are set on a multifamily unit to scale your real estate investing plans.
Your sights are set on a quadraplex (4 unit building) on sale for $800,000. By now, your first rental property has appreciated in value over the years while the tenant pays the mortgage down.
Here comes the loop hole used by the rich to avoid taxation...
Tax Loop Hole
Using the 1031 Exchange, the investor can sell their original rental home at a profit and not pay taxes if the proceeds are used to purchase another "like-kind" investment property, even if the new property is larger or more expensive.
This is how the rich level up their real estate investments without having to use any additional cash.
So, let's say the original rental home is sold for a profit of $275,000. Ordinarily, the selling of an investment property is a taxable event and the tax payer would have to pay taxes on the entire $275,000 gain. However, the entire tax liability is deferred if the proceeds are used to purchase the $800,000 quadraplex, which can earn more money each month with four tenants.
Avoiding Taxation For Heirs
The 1031 Exchange process can continue until your death without owing any taxes on the sale of the exchange. Let's say that at the time of death, the perpetual 1031 Exchange process has result in a $10,000,000 apartment building. After death, the $10M apartment building can be passed on to heirs tax free.
The heirs to the inherited property will only have to pay taxes on the property if they sold it for a gain. For instance, if the heirs eventually sold the $10M apartment building for $11M, then taxes would be owed on the $1M gain. This is because the heirs received a favorable step-up in tax basis when they inherited the property.
There are tons of tax loopholes out there for those who who know about them. So remember, knowledge is power and hopefully this information has made you a bit more powerful.