1031 Real Estate Exchange for a Physician Investor | 1031 Exchange Definition
“You must pay taxes. But there’s no law that says you gotta leave a tip.” – Morgan Stanley
How Can Physicians Investing in Real Estate Avoid Paying More Taxes?
Remember the common saying that you can have multiple real estate tax benefits? Your eyes can only see what your mind knows. Not many physicians know about 1031 real estate exchange. The 1031 real estate exchange is one of the many ways by which investors can take advantage of real estate tax benefits and have their money grow in a tax-deferred way. The 1031 real estate exchange provides an opportunity within real estate investments to avoid paying more taxes on capital gains (the real estate returns you make when you sell an investment property). Here’s how the 1031 real estate exchange work for a physician investor.
1031 Real Estate Exchange for a Physician Investor: What Exactly is It?
Internal Revenue Code (IRC) Section 1031 is a provision that defers tax on qualifying exchanges of like-kind real estate. It is also known as the ‘Starker Loophole’ or ‘Like-Kind Exchange’. When you sell an investment real estate property that you own, you make real estate returns and you have to pay capital gains taxes on it. The 1031 real estate exchange allows you to completely defer those taxes, if you reinvest that money into a similar property, in a timely manner.
- First, you need to realize that the government taxes your profits in real estate. This means that on any investment, the government will keep its cut of your profit. This is known as the capital gains tax. In real estate, paying this tax can be avoided. Yes, there is such thing as real estate tax benefits.
- Example: Let’s say you saved up some money and bought a multifamily rental property ‘A’, using $500,000 USD. You renovated this property, a few years down the lane, you feel like the property has reached its potential, and you want to sell it. The price has appreciated to $700,000 USD. If you sell the property, you will make a profit of $200,000 USD and you will have to pay capital gains taxes on this profit. What the 1031 real estate exchange allows is, you can completely defer paying this capital gains taxes. You can do this, if you are able to buy a similar real estate property (multifamily rental property ‘B’) within 180 days of selling your prior property ‘A’, and using those proceeds to buy property ‘B’.
- The 1031 real estate exchange allows you to only defer but not eliminate this payment of the capital gains tax.
- To do this, you must provide necessary documentation that the money (or parts of it) for your new property came by selling the old property.
- This entire process is completely legal and exists under Section 1031 of the IRS Code.
|“LIKE KIND” PROPERTIES |
CAPITAL GAINS TAXES
Real Estate Tax Benefits – 1031 Real Estate Exchange for a Physician Investor
Medical practitioners generally earn more than an average income and have the necessary finances to invest their money into real estate assets. A 1031 real estate exchange can help you save a size-able amount of money. Let’s see this with an example.
- If I am a physician entrepreneur and I have $1,000,000 USD in the form of a real estate asset, if I sell this property, I can use that to buy another new and better real estate property. Now normally, say a 15% federal tax rate on my capital gains would mean that I pay $150,000 USD in taxes and I actually have $850,000 USD worth of investment funds.
- If you can prove that the investment funds for the new real estate you’re about to buy came from another real estate asset, you can keep this 15% too.
- This means that you no longer only have $850,000 USD from the total $1,000,000 USD. The $150,000 USD that the government would normally keep is also yours using the 1031 Exchange.
- This $150,000 USD can now be realized in the form of another investment.
Advantages of Investing in Real Estate
- Deferring your Taxes: By making use of the 1031 real estate exchange, physician entrepreneurs investing their savings can defer paying the capital gains tax. Your money can grow in a tax-deferred way, which over time will increase your assets or wealth–by providing you with more capital to invest into more or bigger deals, and the income you make from these properties.
- Providing a Cash Flow: Saving money by deferring taxes will give you more cash on hand, so it will help with efficient operations of the new project.
- The Exchange of Real Estate: The 1031 real estate exchange can help two investors who both have real estate assets and wish to exchange properties. Normally doing this would invite government scrutiny through taxes applied. But, you don’t have to worry about maintenance costs in such a scenario.
- More Wealth: In the longer run, physician entrepreneurs investing in real estate would be earning more money because of the taxes deferred. This also helps in increased asset accumulation, helping you build a more diverse portfolio.
Disadvantages of Investing in Real Estate
- Complex Procedure: The regulations, rules and multiple procedures attached with the 1031 real estate exchange can seem extremely complicated. For medical practitioners not familiar with tax jargon, this can present itself as a problem. You’ll definitely need to hire a tax consultant with experience in 1031 real estate exchanges.
- Meeting the Rules Attached with the 1031 Real Estate Exchange: The regulations presented by the IRS to enjoy the 1031 real estate exchange can be difficult to comply with. For example, the new real estate asset being purchased must be shortlisted within 45 days of the old real asset that is being sold off, and must be bought within 180 days of selling the old asset.
- Taxes on the Deferred Gain: If you ever decide to sell the new property acquired, the deferred gain will be taxed.
- No Profit Recognized, No Loss Recognized: Just as the capital gains tax will be avoided during this transaction, any losses will also be deferred. Hopefully, you did not lose money from your previous property.
How to Set Up and Use the 1031 Real Estate Exchange
By following the below listed steps, you can set up and use the 1031 real estate exchange to defer your taxes. The steps are:
- Step 1: Before submitting the sale of property in the form of a contract, make sure to file the Relinquished Property Addendum (RPA) form. This helps prove intent within documentation regarding the purchase of the new real estate asset.
- Step 2: This step involves the preparation of the funds required for this transaction. This is done through the settlement attorney, and a copy of the exchange fee voucher along with the settlement statement is issued to all parties involved.
- Step 3: Once the original real estate asset is sold, the investor only has 45 days to nominate the new real estate that will be purchased. The investor can at most nominate three potential properties that will be decided upon and then get a fair value listed for them.
- Step 4: Once the new real estate that you wish to purchase is decided upon, a 180-day period is given to transfer the asset to your ownership.
- Step 5: Another copy of the Relinquished Property Addendum (RPA) needs to be provided when the contract for the new real asset is created.
- Step 6: Using the IRS Report Forum 8824, you’ll need to file for the complete transfer of property which will serve as legal evidence.
Conclusion: How Can the 1031 Real Estate Exchange be Used to Save Taxes Over the Long Run?
For any physician looking to invest his or her hard-earned money in real estate, 1031 real estate exchange provides an excellent opportunity to defer paying taxes on any real estate profit. This means that if you’re continuously selling and purchasing real estate, this tax code can help you save a significant sum of money over the long run.
Suppose that the average tax you pay on any real estate sale is around $90,000 USD. If you were to sum this value up to a long period of time such as 5 years, imagine the number of times you’ve had to pay this $90,000 USD. By using a 1031 real estate exchange, you can keep all of your capital gains without any giving any cut to the government. This helps you increase your wealth over the long run.
Here at PhysicianEstate, we welcome all physician entrepreneurs to learn about commercial real estate investments, rental property investments, and wealth generation. We encourage all physicians to eventually become real estate physician investors. We know a great deal about Who – What – Why – How.
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