Most people who have built wealth - and investment advisors - will recommend that real estate should be a large portion of your investment mix. For a lot of wealthy folks, real estate may make up the largest portion of their investments.
Why do the wealthy invest in real estate? Some believe that real estate is a safe investment over time. Many like that it is tangible. Some savvy investors will point out that they can use leverage to get into a property, and the property can provide more than one source of return on investment.
Most investments require that you have all of the cash up front. Think about buying stocks, bonds, CD’s and so on. If you want to be able to purchase a $500,000 investment, you will likely need $500,000.
That is not necessarily the case with real estate. With a minimum of 25-30% down a person could potentially buy a $500,000 property. You could rent the property and potentially cover your expenses and make a profit. Later you could sell that property and use the proceeds to buy one or more additional properties. Historically real estate prices have increased 4-6% a year, so your return on investment results from the increase in value during the holding period in addition to the potential cash flow with an investment property.
Most investors that are growing wealth with real estate use leverage to get started and take advantage of 1031 exchanges to keep all of their money working for them, deferring any capital gains and building wealth for future generations.** Capital gains taxes can range from a minimum of 15% to over 30% on the sale of an investment property.
Savvy investors have figured out how to invest in properties for positive cash flow, buy and hold for long term passive income and create a legacy with their real estate and build generational wealth using strategic 1031 exchanges. They know that their heirs will benefit from what is called the “stepped up basis” when they inherit a property.
How does the stepped up basis benefit your heirs? Let’s say someone owns a property that they bought years ago for $100,000. That used to be a lot of money, right? And let’s say that property is worth $1,000,000 today. If they sold it without doing a 1031 exchange, they would likely have to pay 15-30+% capital gains tax on all of the gain.
However, if the heirs inherit the property, they get what’s called a stepped-up basis. They inherit the property with a tax basis of $1,000,000. So, if the heirs turned around and sold it for $1,000,000, there would be no capital gains. Some investors have chosen to exchange larger investment properties for several smaller properties so that individual heirs can inherit properties that meet their individual needs and the investor can avoid future conflicts among family members.
If you are an investor who is over 60 years old, you owe it to yourself to learn how you can build wealth for your family and have your heirs avoid paying capital gains tax when they benefit from the stepped up basis.
For more information on 1031 exchanges go to Maui1031Exchange.com. For more about Barbara and Lee visit AlohaGroupMaui.com.
** This is not tax advice – please consult with your tax professional.
1. What is a 1031 exchange?
a. The Internal Revenue Code allows you to sell real property and defer payment of capital gains tax if you use the proceeds to acquire a “like kind” property.
b. The code also provides that the gain is not recognized if property held for investment or productive use in a trade or business is exchanged for property held for investment or productive use in a trade or business.
2. What are the advantages of doing a 1031 exchange?
a. Defer your capital gains tax – federal rates for long term capital gains are 15-20%+, Hawaii tax rate for long term capital gains is 7.25%.
b. You can replace a non-performing property or relocate your investment into one or more properties in a different market that better meet your goals.
3. What is the long-term advantage if you continue to defer gains through 1031 exchanges?
a. You can defer taxes and liquidate when you are in a lower tax bracket.
b. Your heirs can inherit property on a stepped-up basis and pay no capital gains taxes upon your demise.
c. You can eventually move into a property, own it for 5 years, live in it for at least 2 years, and then claim the homeowner gains exclusion.
4. What is a like kind property?
a. Any real estate held for investment or productive use in a trade or business
b. Exclusions include personal property, leasehold property with less than 30 remaining years on the lease, and property outside the US or US territories (not including Puerto Rico)
5. Can you exchange into a lower priced property and take out some of the cash?
a. Yes - you would pay capital gains on the cash, or “boot” taken out of the transaction, but could still defer some of the gain.
6. Is it a good time to do a 1031 exchange?
a. Yes, if you have a significant amount of equity and want to upgrade or increase your portfolio or relocate an asset.
b. You can still take advantage of historically low interest rates and lock in a rate on a new property at a low rate before further increases.
c. You can strategically plan your goals now to help your family with real estate and create a financial plan to leave a legacy.
d. You can restart the depreciation clock on a fully depreciated property.
7. What is the best way to plan an exchange?
a. Work with an expert to identify your long-term goals and investment strategy.
b. Begin searching for a replacement property at the same time you prepare the property you plan to relinquish for sale.
c. Locate 3 replacement properties before your sale contract opens escrow.
d. Seek advice from a knowledgeable REALTOR, CPA, financial planner, attorney.
Did you know that a 1031 Exchange allows you to defer taxes on the sale of an investment property when you purchase another investment property? You can exchange (sell and buy) almost any real property for another real property. A common misconception is that an exchange has to be a house for a house, a condo for condo and so forth. That’s not the case. It could be a condo for a home, land for a condo, two condos for a commercial property, or other type of exchange for fee simple real estate.
Deferring your capital gains lets you keep your money if you re-invest in another property (or properties) of equal or greater value.
You may, for example, decide to sell a property that is not performing well and replace it with a more productive property. Some of our clients have decided to sell a Maui property for something closer to home on the mainland. Some of our clients have sold mainland properties to make their Maui dream come true.
We bought a 3 bedroom house in Reno that our son lived in while in college and rented the other bedrooms to pay the mortgage. When he graduated we sold that house using a 1031 exchange and leveraged it into two condos on Maui.
The 1031 Exchange can be a great planning tool to build wealth for yourself and your family and create your legacy. You can use strategic replacement properties to diversify your holdings and pass wealth to your heirs. Planning ahead means your heirs could inherit a property with a stepped up basis that could further reduce any capital gains and possibly be in locations that might better suit their future needs.
Property owners will need to work with tax advisors and a Qualified Intermediary in addition to a professional realtor to accomplish the exchange process.
Aloha Group Maui offers free seminars in Maui to inform the public about 1031 Exchanges and other wealth building opportunities in real estate.
Aloha Group Maui Keller Williams Realty Maui can help you buy or sell a home or condo - for you to live in full time, part time or as an investment. Learn more about Maui Real Estate in our Maui Real Estate 101 resources section. Stay informed of market trends by reading the Maui Real Estate Advisor. We are your Maui Real Estate Professionals.