A Tax Tutorial for the Real Estate Investor

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By Benny L. Kass
Saturday, February 2, 2008

Last in a series of columns

"The only difference between death and taxes is that death doesn't get worse every time Congress meets."

-- Will Rogers

In this series of tax articles, I have discussed tax benefits for owners of residential properties. Now we turn to the benefits available to real estate investors.

Generally, if you sell investment property, you will have to pay capital gains tax on the profit. For 2007, the top long-term capital gains tax rate was 15 percent.

Investors are required to depreciate a portion of their property every year. This may provide a small yearly tax benefit, but when the property is ultimately sold, in many cases this depreciation must be recaptured -- at the rate of 25 percent.

Enter the like-kind exchange, also known as a Starker exchange or Section 1031 exchange. The exchange, which is authorized by Section 1031 of the Internal Revenue Code, will defer the capital gains tax. It will not relieve you of the ultimate obligation to pay at some time in the future if you sell during your lifetime.

The ideal exchange is a direct swap: I own investment property A, and you own investment property B. They are of equal value. On Aug. 1, 2007, you convey B to me and I convey property A to you. If we have a written agreement that this is to be a 1031 exchange, neither of us will have to immediately pay any capital gains tax on our profit.

But it is almost impossible to arrange such a simple transaction. Accordingly, most 1031 exchanges today are deferred.

There are two kinds of deferred exchanges:

  • A forward exchange. You sell the relinquished property, and within the time limitations spelled out in Section 1031, you obtain the replacement property.

  • A reverse exchange. You obtain title to the replacement first and then sell the relinquished property.


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