Tax Deferred Exchanges — 1031s — THE Crucial Question
I literally haven’t a clue how many exchanges I’ve executed in my career. When asked, I usually just say ‘over 200′ cuz that’s when I stopped the silly practice of keepin’ score. Wanna know how to prove I’ve never had an exchange disallowed or fail? That one’s easy — cuz I’m above ground writin’ this. Seriously, what would you do if somebody cost you five or six figures in taxes you never should of owed? After doing a few dozen I realized most folks seemed to think the tax deferred exchange was evidence they’d made it as an investor. Nothing could be further from the truth. Fact is, if by planning or just plain luck you can manage to avoid a 1031 exchange, and still come out smilin’, you’ll most often be better off. That statement surprises many investors, always has. So, the crucial question is: Do I really need to execute a tax deferred exchange, or is there a superior alternative?The ability to defer capital gains taxes (and other taxes) is simply a tool found in Section 1031 of the Internal Revenue Code — NOT the be all, end all magic wand of real estate investing. In fact, using it needlessly will actually penalize the investor as time passes.There are many consequences not necessarily beneficial resulting from 1031 exchanges. Possibly the biggest pain in the patute is the baggage you, as the exchanger must carry with you — adjusted basis. (Oversimplified stoopidly to the max, it’s price paid, minus depreciation, plus capital improvements, plus costs of sale.) Adjusted basis is like the freakin’ Scarlet Letter for some. It decreases what might’ve, or more accurately put, would’ve been your annual post transaction depreciation. It also — and this is understated as merely critical to understand — increases your capital gain if you ever sell what the IRS lovingly refers to as ‘the acquired’ property(s). Over the years I’ve had the pleasure to have saved dozens of taxpayers literally millions of dollars in completely unintended capital gains taxes. Most of the time it was a direct result of either the investor or their agent calling me to ‘make sure’ they were doin’ things according to the IRS version of Hoyle. Um, no, you aren’t. Though I have myriad war stories on that point alone, a guy in my own town of Paradise, I mean, San Diego, probably has 20 for every one of mine. His name is Bill Exeter, and if you’re a serious long term investor, you either need to know him, or somebody like him. He, or more accurately his firm, specializes as a Qualified Intermediary — what guys like me call an Accommodator. I’ll let him explain what that is next week.Here’s why.For every rule found in Sec. 1031 most real estate investors think they know, there are a few related rules of which they’ve never heard.