The federal and state government encourages citizens to invest in real estate and gives tax benefits to real estate investors that is not available to investors of stocks. Investing in real estate is not for everyone. Most of the investors that have invested in real estate over the years have done very well and they have a source of cash flow from the rental income.
The tax breaks are different for those that buy a home to live and for those that buy investment property. The federal government passed a law in the early 1990s that changed the tax laws on the sale of personal residences. If you live in your primary personal residence 2 of the last 5 years, there is no tax on the gain up to $250,000 for single owners and $500,000 for married couples. The house that you sell must be your primary personal residence and it cannot be your second personal residence. The government allows you to do this every 2 years. Let's say you buy a house that looks terrible but is structurally sound and fix it up and live in it for 2 years. You can live in the house for a year, rent it out for 3 years, move back in for 1 year and still qualify for the tax break because you lived in the house for 2 of the last 5 years. You can sell the house and pay no tax on any profits up to $250,000 and $500,000 as mentioned above. Young people can buy a place and fix it up and live there for 2 years and pay no tax on the gain up to their limits and repeat this process over and over again every 2 years. This is a tremendous way to build up equity, have a place to live and pay no tax on the gains.
You could buy the property with a relative or a friend and both of you could live in the house and each of the owners that are on title could take their proporationate share of the profits and take the tax benefit. Joint ownership of property would be great for those of you that cannot afford to buy the house on your own. You could also invite your family to be investors in the property if you can qualify for the loan but don't have the down payment and you can live in the house and take the tax deductions. You must consult with a CPA before you undertake any investments so that you can be sure that you are eligible for the tax benefits.
If you buy an investment property, the rules are different. Let's say you bought an investment property for $100,000 many years ago and it has gone up in value to $600,000. If you sold it, there would be a taxable gain of $500,000 minus any depreciation that you may have taken on the building. Depreciation recapture is treated differently and you need to consult with a CPA to get the right information and guidance. The government allows you to sell the investment property and buy another like kind investment property for equal or higher value than the property that you sold. You must buy an investment property for $600,000 or more. If you buy a property for less than $600,000, the difference is called 'boot' and you have to pay tax on that difference.
T.J. Starker owned timber land and sold the property to Crown Zellerbach in the 1960s. If you heard of Crown Zellerbach, you are an old timer because Crown no longer exists under that name. Starker wanted to do an exchange and found suitable replacement property 5 years after he sold the property to Crown. The IRS said that Starker took too long to find a replacement property and Starker and the IRS went to Supreme Court and Starker won. Starker won because the Internal Revenue Code did not have a time line in the law as to when you had to find a replacement property. This became a historical court case regarding exchange properties.
The IRS changed the rules to state that you must identify the replacement properties within 45 days of closing on the relinquished property. You must also close within 180 days of closing on the relinquished property. Failure to meet these 2 deadlines would most likely result in the tax deferred exchange being nullified by the IRS and the taxpayer must pay the tax on the gain. There are several options on how you can identify the replacement property. The first is called the 3 property rule. You can identify up to 3 different properties to be your replacement property and there is no limit on the value of the 3 properties that you have selected. In the example above, you have to buy something that is $600,000 or higher. You can select 3 properties that could have different values. One could be $400,000, another could be $800,000 and the third could be $1,000,000. The second option is called the 2X rule. You can identify unlimited number of properties but the aggregrate total of all the properties cannot exceed 2x the value of what you sold. In this case, the aggregate total cannot exceed $1,200,000.
If the 45th day to identify the replacement property falls on a weekend, you must fax or email with your scanned signature, the replacement properties before the 45th day expires. If you send the replacement list on the 46th day from the date of closing, you lost the right to do a 1031 exchange. If the 180th day to close is on a weekend or on a holiday, you must close before the 180 days are up or you may pay penalty and taxes.
The next article will deal with the players involved in the exchange process and their roles. 1031 exchanges are very complicated and full of potential problems if the people you work with do not understand the process. I teach a 1031 exchange class with Julie Tumbaga from Old Republic Exchange Co. You are welcome to attend the class as my guest and I will waive the $50 class fee if you agree to work with Abe Lee Realty in a transaction. Feel free to call me at 216 4999 or email me at
abelee@hawaii.rr.com. Feel free to visit my websites
www.abeleeseminars.com and
www.abeleerealty.com. Please give me feedback on the articles and let me know how I can improve.
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