One might ask: Why go to the trouble of qualifying a transaction as a §1031 like-kind exchange? The Internal Revenue Code (hereinafter referred to as the "Code") is difficult enough to understand without digging into a complex section that could result in more tax complications.
However, there are a number of advantages to a §1031 exchange:
- The most obvious advantage is tax savings. Using this and other sections of the Code wisely, you can defer taxes, sometimes for the rest of your life. This means the money that would otherwise have gone to pay taxes is now available for investment - and is interest-free because the taxes have been deferred under §1031.
- You can increase the depreciable basis of the property you acquire by encumbering it with a larger debt.
- You can add sheltered income to your investment portfolio by exchanging your unimproved land for income-producing improved land.
- You can acquire a new property without cash and can dispose of property via an exchange when an outright sale might not be possible in the existing economic climate.
- You can pick up some nontaxable cash by exchanging property and then refinancing after the exchange.
- You can diversify your holdings without paying the taxes normally associated with a sale and purchase of new holdings.
- The tax savings to your client (or to you, as an investor) are not only substantial but can also, with the benefits of leveraged purchasing, make a tremendous difference in the ultimate value of a real estate investment portfolio.
- Because of the tax savings, the availability of a §1031 exchange may even make the difference between no sale at all and multiple sales (with multiple commissions). Just making the client aware of some of the possibilities of a §1031 exchange may open up all sorts of future transactions that would not otherwise have occurred to him or her.
- Because of the flexibility built into the §1031 rules, it is not necessary to find the property you wish to acquire and then arrange a simultaneous exchange for the property you are selling. In fact, there are ways to exchange your fully developed property for vacant land, build a custom building on that land, and still have the entire transaction qualify under §1031.
In addition, we all know that the bar is always on the rise when it comes to the professional real estate agent's obligation to be well-versed in the latest tax rulings, zoning regulations, interest rates, and all other matters that might have an impact on a client's plans. While we are obviously liable for erroneous advice, we can also be held accountable for failing to offer information that a client might find valuable. Again, your knowledge of the possibilities under §1031 might make the difference between a disgruntled or even litigation-minded client and one who participates in numerous transactions that are more lucrative for you than typical sales and purchases of property.
In most §1031 courses, you will encounter numerous examples of how a particular transaction might work from a tax standpoint. While instructors will explain how many of the tax calculations are done, we will not go into every detail of every calculation. Those sorts of details are better left to an accountant or other professional who is familiar with this area of taxation. You need not be concerned with whether the tax result is correct to the penny. Your primary interest is in understanding how an exchange can make a substantial difference in the tax result so you can explain it to your client.
Finally, unless you are quite familiar with the main terms used in tax law, this would be a good time to recommend appropriate tax and legal counsel to your clients. A thorough understanding of common tax-related terminology will also make the process much easier to engage with and follow. Of particular importance are the concepts of cost, basis, depreciation, realized gain, and recognized gain.
VanEd offers a Real Estate Continuing Education course on §1031 Exchanges. Learn more and Register online at VanEd.com.
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