Real Estate Investments - 1031 Exchange
26 Oct 2020 - Nuruddin Pethani
Photo Credit: Patrick Tomasso
“I want to pay as much income tax as Trump paid and no more.” Dr. Venky told me.
“Sir, for that, you have to leave your medical practice and just have real estate investments,” I replied.
Let me explain.
Say you bought an apartment in New York for 1 million dollars. To make it easy to understand, let’s assume you have no mortgage.
Rent is $4,200 per month. Real estate taxes are $1,000 per month, and Maintenance fees are $900 per month. The tenant pays all other expenses.
So the net income is: Rent - Real estate taxes - Maintenance fees = 4200 - 1000 - 900 = $2300 per month.
So the yearly income is: 2300 X 12 months = $27,600
Now is the surprise; Even though you have a monetary income of $27,600, you don’t pay any taxes.
Why? The reason is depreciation. Residential property is depreciated over 27.5 years, which means that if the property costs 1 million, you get a depreciation deduction of 36,364 every year. ( 1 million divided by 27.5)
So in your tax returns, instead of showing a profit of $27,600, you have a loss of 27,600 - 36,364 = $8,764.
Any bad parts? Yes. You cannot write off the loss of 8,764 against your regular income from your job or practice. This loss is passive and can only offset other passive income or get carried forward to next year, or you get the total loss when you sell the property.
The other thing to note is if you keep the property for 30 years. In 27.5 years, the property is 100% depreciated, and the book value of the property for tax purposes is now “Zero.”
1031 Exchange
The market value of the property you bought for 1 Million is now 2 Million after 30 years. If you wish to sell the property, the entire 2 Million will be a capital gain. To avoid this, you can take the benefit of a tax provision called “1031 exchange.”
In a 1031 exchange, you cannot touch the money at the sale of the property. It has to remain in escrow with a qualified intermediary, usually your attorney. You have 45 days from the closing to identify a property that you will buy. You have 180 days from the closing to go ahead and buy the new property. This new property should be higher in value than the property sold. All the money received from the old property has to be invested in the new property. In this way, you can defer the entire gain on the property.
Stepped-Up Basis
There is one more exciting provision in the estate law called a stepped-up basis. When someone inherits a property, the basis for that property (cost price for tax purposes for the seller) becomes the market value on the person’s death.
Let’s take the case of the above property, which was bought for 1 million. Say after 30 years, the value shoots up to 2 Million, and the property is completely depreciated. If you sell the property, you pay taxes on 2 Million. But, if your son or daughter inherits the property on your death and sells the property, the gains would be zero due to a stepped-up basis, thereby saving them huge sums in taxes.
Talks are going on right now to end this provision. Let’s hope it doesn’t happen.
Disclaimer: Every situation is different. Please consult your tax advisor, which we hope is our firm.