How Property Investors Can Defer Capital Gains Tax By Using Section 1031

As a real estate investor, you must be aware that each and every dollar that you have working for you in an investment is making you money, and, conversely, every dollar that isn't working for you represents a lost opportunity to further compound your profits. So, when the time comes to put your property up for sale, you have two options. The 1st option that you have at your disposal is simply to make a outright sale and recognize a gain. This means you must pay capital gains taxes. Whenever you pay money to the United States government you are losing potential profits.

The second, and often more lucrative option is to conduct a 1031 exchange. A great way to keep more of your investment funds making you more money is to conduct an exchange instead of making an outright sale. Section 1031 has a non-recognition provision, meaning you do not have to pay the taxes immediately; in fact, you can defer the taxes indefinitely, while your wealth is compounded by the extra income produced by investing your tax deferment.

As an example, let's say you own some small investment properties, like duplexes, whose values have increased over time. At this juncture, your first inclination might be to make an outright sale and reap the benefits of your investments. But a wise investor with an eye to the future might decide to conduct a 1031 exchange and place the proceeds from these smaller investment properties towards the purchase of another, larger property, which will, itself go on to appreciate in value over time, meanwhile continuing to make you more money. Additionally, the money available to you from your capital gains deferral will function to increase your ability to leverage for greater loans, maximizing your potential profits.

1031 exchanges aren't just for land and buildings, either. It is possible to make a 1031 exchange on any sort of real estate held for investment in your business or trade, as well as certain kinds of personal property, from cranes or backhoes to an aircraft or collector car. Section 1031 is especially beneficial for those who have money in antiques or collectibles like collector cars, because of the higher capital gains liability on the sale of these items. It is important to note, however, that you cannot make a 1031 exchange on stock, bonds, or interest in an REIT.

So, next time you find that you are planning to sell an appreciated piece of real estate or other property, pause for a moment to think of the future dividends you could reap were you to make an exchange. If you decide to conduct an exchange instead of selling your property up front, you can maximize your wealth and come out on top.

Down Size With Reverse Mortgage, Move Your Tax Base & Take A Capital Gains Exemption? It's Possible

A future trend for Southern California Boomers? For Boomers and Seniors living in other areas, two out of three isn't bad either.

The house is big, the kids are gone, you're tired of maintaining the yard and you and your spouse only use half of the house. Could it be time to move and at the same time increase your retirement nest egg and cash flow?

The passing of HR. 3221 and the modernization of FHA and reverse mortgages is a step in the right direction in helping boomers and seniors plan for their retirement. The improvement is yet to be measured but here are some interesting thoughts.

Within the last couple of weeks the president signed into law HR 3221. Amongst many things, this law will do is dramatically change reverse mortgages. It will:

o Increase the loan limits for reverse mortgages (limits have yet to be defined publicly by HUD) - which means more liquid cash for reverse mortgage recipients.
o Capped origination fees - 2% of the first $200k of the maximum claim amount, plus 1% of the balance above $200k to a maximum origination fee of $6000. On average this will reduce origination fees by over $1200 for Southern California reverse mortgage borrowers.
o Enable to use the FHA HECM reverse mortgage for HOME PURCHASE
o Enable the FHA HECM reverse mortgage to used on co-ops, amongst other improvements

In 1986, California voted to provide tax relief (Proposition 60) to homeowners older than 55 by allowing (with some restrictions) to transfer their existing property tax base to replacement homes of the same or a lesser value within the same county or a participating reciprocal county (Proposition 90). As the boomers begin to retire and look to trade into smaller, age friendly single story homes, or consider 55+ communities, using this proposition may become more popular. You can use this benefit one time. There are numerous restrictions including a single person or spouse must be 55 years old when selling your original property. Your new property must be a principal residence with the current market value equal or less than your original residence. Proposition 60 covers property transfers within the same county. Proposition 90 allows property tax base transfers with participating counties of Alameda, Los Angeles, Orange, Santa Clara, San Diego, San Mateo and Ventura counties. Be sure to contact your tax assessor's office for current information.

Taxpayer Relief Act of 1997 changed the way real estate capital gains taxes are calculated. The IRS issued updates in 2003. This rule offers up to $250,000 tax free sales home profits for a single person and up to $500,000 profits for a couple. To qualify the seller must have owned and occupied their principal residence a total of two of the five years before the home sale. (Consult your tax expert for updated advice)

Even with today's softened housing market, many home owners have substantial equity in their homes. There is an opportunity to take advantage of these gains and improve your retirement plan with multible opportunities.

Here is an example:
Mr. & Mrs. Jones both age 70, sell their current home for 1 million in Los Angeles County; Original cost of home: $250,000; Mr. & Mrs. Jones decide to buy a home for $500,000 in Ventura County. Gain on the sale: $500,000; Exclusion for couple filing jointly: $500,000; Taxable gain: $0. Mr. and Mrs. Jones transfer their original property tax base with them, keeping their original property tax base. They take their $500,000 exemption and buy their home in Ventura County with a FHA HECM reverse mortgage. The FHA HECM reverse mortgage allows them to either pay $300,000-$320,000 for their $500,000 home, they have no mortgage payment and they pocket the difference tax free. Mr. and Mrs. Jones may also purchase their new $500,000 home with a reverse mortgage and further increase their monthly cash flow by $6-700 a month buy opting for the tenure payment option for life.

All three of these opportunities will soon be available to many Southern California retirees. The capital gains exemption is available to everyone. As soon as HUD issues the green light, FHA reverse mortgages will be available for use in home purchases for borrowers 62+ years old, throughout the USA.

The Boomer generation turned 62 this year. With the increasing popularity and practical application of reverse mortgages into the main stream, it is not unreasonable to expect to see the incorporation of these and other cash flow tools in retirement planning on an increasing basis.

Tax Tips for Real Estate Investors Using IRA Funds

You've seen the advertisements and news articles. IRA funds can be used to make real estate investments. But before you jump on this bandwagon, make sure you understand some of the tax planning angles related to this opportunity.

Passive Loss Deductions

Almost always, an important component of your real estate profits comes from the tax savings associated with depreciation. These paper losses, referred to as passive losses by the Internal Revenue Code, can save both small and professional real estate investors thousands of dollars a year in income taxes. Unfortunately, passive losses from depreciation and related, similar tax deductions won't benefit real estate investors investing through IRAs.

Capital Gains Preferences

If you sell an investment for a profit--whether a stock or real estate--you get a tax break because your profit gets taxed at a preferential capital gains tax rate. In the best case scenario under current tax law, for example, your capital gains get taxed at 15% rather than at 35%.

Unfortunately, by putting real estate inside of an IRA, you lose this benefit. In effect, the appreciation you enjoy from your real estate investment gets taxed at your marginal income tax rate rather than at the capital gains rate. (Fortunately, the tax gets paid when you withdraw the money.)

Note: This "problem" also exists for other investments that produce capital gains, such as stocks and mutual funds that invest in stocks.

Unrelated Business Income Tax

In certain special circumstances, an IRA needs to pay income taxes on the profits it generates. These taxes, called unrelated business income taxes, essentially put the IRA investor in the same position as a regular taxable investor.

For example, if you're developing and then flipping properties inside your IRA, you may actually be an active trade or business. And in this case, your real estate investment--even though it's inside an IRA--may be subject to income taxes. (Your IRA custodian is supposed to report your taxable income and tax liability, and then pay the taxes but many don't...)

And here's another example of a situation where the unrelated business income tax can trip you up. If you borrow money to invest in real estate--the typical situation in any leveraged real estate investment--the profit you earn on the money you've borrowed is treated as unrelated business income. Accordingly, that profit is subject to unrelated business income tax.

Unrelated business income inside an IRA is taxed according to trust taxation rules, which means that as soon as you've made much money at all, you're taxed at the highest marginal tax rates. Ouch.

Closing Caveats

Real estate is a great investment. And real estate belongs in any investor's portfolio. But you need to think carefully about buying into the idea of using your IRA to make real estate investments. If you do decide to invest in real estate through your IRA, first consult with your tax advisor.

Investors: Avoid These 5 Common Tax Mistakes

For many investors, and even some tax professionals, sorting through the complex IRS rules on investment taxes can be a nightmare. Pitfalls abound, and the penalties for even simple mistakes can be severe. As April 15 rolls around, keep the following five common tax mistakes in mind - and help keep a little more money in your own pocket.

1. Failing To Offset Gains

Normally, when you sell an investment for a profit, you owe a tax on the gain. One way to lower that tax burden is to also sell some of your losing investments. You can then use those losses to offset your gains.

Say you own two stocks. You have a gain of $1,000 on the first stock, and a loss of $1,000 on the second. If you sell your winning stock, you will owe tax on the $1,000 gain. But if you sell both stocks, your $1,000 gain will be offset by your $1,000 loss. That's good news from a tax standpoint, since it means you don't have to pay any taxes on either position.

Sounds like a good plan, right? Well, it is, but be aware it can get a bit complicated. Under what is commonly called the "wash sale rule," if you repurchase the losing stock within 30 days of selling it, you can't deduct your loss. In fact, not only are you precluded from repurchasing the same stock, you are precluded from purchasing stock that is "substantially identical" to it - a vague phrase that is a constant source of confusion to investors and tax professionals alike. Finally, the IRS mandates that you must match long-term and short-term gains and losses against each other first.

2. Miscalculating The Basis Of Mutual Funds

Calculating gains or losses from the sale of an individual stock is fairly straightforward. Your basis is simply the price you paid for the shares (including commissions), and the gain or loss is the difference between your basis and the net proceeds from the sale. However, it gets much more complicated when dealing with mutual funds.

When calculating your basis after selling a mutual fund, it's easy to forget to factor in the dividends and capital gains distributions you reinvested in the fund. The IRS considers these distributions as taxable earnings in the year they are made. As a result, you have already paid taxes on them. By failing to add these distributions to your basis, you will end up reporting a larger gain than you received from the sale, and ultimately paying more in taxes than necessary.

There is no easy solution to this problem, other than keeping good records and being diligent in organizing your dividend and distribution information. The extra paperwork may be a headache, but it could mean extra cash in your wallet at tax time.

3. Failing To Use Tax-managed Funds

Most investors hold their mutual funds for the long term. That's why they're often surprised when they get hit with a tax bill for short term gains realized by their funds. These gains result from sales of stock held by a fund for less than a year, and are passed on to shareholders to report on their own returns -- even if they never sold their mutual fund shares.

Recently, more mutual funds have been focusing on effective tax-management. These funds try to not only buy shares in good companies, but also minimize the tax burden on shareholders by holding those shares for extended periods of time. By investing in funds geared towards "tax-managed" returns, you can increase your net gains and save yourself some tax-related headaches. To be worthwhile, though, a tax-efficient fund must have both ingredients: good investment performance and low taxable distributions to shareholders.

4. Missing Deadlines

Keogh plans, traditional IRAs, and Roth IRAs are great ways to stretch your investing dollars and provide for your future retirement. Sadly, millions of investors let these gems slip through their fingers by failing to make contributions before the applicable IRS deadlines. For Keogh plans, the deadline is December 31. For traditional and Roth IRA's, you have until April 15 to make contributions. Mark these dates in your calendar and make those deposits on time.

5. Putting Investments In The Wrong Accounts

Most investors have two types of investment accounts: tax-advantaged, such as an IRA or 401(k), and traditional. What many people don't realize is that holding the right type of assets in each account can save them thousands of dollars each year in unnecessary taxes.

Generally, investments that produce lots of taxable income or short-term capital gains should be held in tax advantaged accounts, while investments that pay dividends or produce long-term capital gains should be held in traditional accounts.
For example, let's say you own 200 shares of Duke Power, and intend to hold the shares for several years. This investment will generate a quarterly stream of dividend payments, which will be taxed at 15% or less, and a long-term capital gain or loss once it is finally sold, which will also be taxed at 15% or less. Consequently, since these shares already have a favorable tax treatment, there is no need to shelter them in a tax-advantaged account.

In contrast, most treasury and corporate bond funds produce a steady stream of interest income. Since, this income does not qualify for special tax treatment like dividends, you will have to pay taxes on it at your marginal rate. Unless you are in a very low tax bracket, holding these funds in a tax-advantaged account makes sense because it allows you to defer these tax payments far into the future, or possibly avoid them altogether.

The 1031 Exchange - Good For Investors, Good For The US

A 1031 tax exchange is a tactic commonly used by real estate investors so that they may defer tax liability on the sale of a property. This is done by transferring the rights to a piece of property one would like to sell to an intermediary, who holds the funds gained from the sale of the relinquished property and uses the money to acquire a replacement that fulfills the regulations set out in Section 1031 .

Although the current interest in the 1031 tax exchange could give you the impression that Section 1031 is a recent development, this is untrue. In reality, the 1031's history stretches all the way back to 1921, although the original concept was significantly different than what we today think of as an exchange. The 1031 Exchange truly came into its own in the '70s, which saw a host of significant modifications in the manner that exchanges were conducted. These modifications resulted in a more powerful conception of the exchange process and also generated increased interest from real estate investors.

The capital gains tax deferral an exchange provides to the taxpayer might, at first glance, seem to be a kind of gift from the United States government, however it is, in reality, closer to an interest free loan, because the taxpayer is expected to "repay" the extra funds gained from the capital gains tax deferral by accepting capital gains liability on the subsequent sale of a replacement property. Additionally, this "interest-free loan" is one that may be kept by the investor indefinitely; an investor can choose to make any number of 1031 exchanges before finally sell outright, at which point capital gains taxes must be paid.

The 1031 exists as a mutually beneficial arrangement between the investor and the United States government, providing a benefit for the country's economy as well as the individual taxpayer. In looking upon the transfer of money in an exchange as a continuation of an existing investment instead of as a discrete transaction liable to be taxed, taxpayers gain the opportunity to move their money to the best possible investments. This, in turn, helps to elevate the economy by bolstering job growth.

As with anything, Section 1031 has skeptics. Some advocates of change in Section 1031 will pose the argument that the tax free income gained by to the taxpayer in a 1031 creates an unfair advantage. Another common concern is that the strict time limits attached to steps in the exchange procedure could promote a frantic rate of buying, with a resultant increase in asking prices for replacement properties. The aforementioned criticisms, however, are only tenuously linked to reality, and the odds that Section 1031 will go through any noteworthy changes in the coming years are quite low. Looking at the big picture, most will agree that Section 1031 is greatly helpful to all involved, as it allows taxpayers greater profits on the sale of property while additionally encouraging job growth and therefore the greater good of the country. There is no reason to doubt that the 1031 tax exchange is destined to remain a mainstay of the investment world for years to come.