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How to Eliminate Capital Gains Tax

Today, a friend and I had a conversation about his real estate investment. He has owned the property for three years now, and we discussed his options if and when he sells his property. So I brought up a "1031 Exchange." To my surprise, he was unaware of the 1031 Exchange and its helpfulness. This is an important topic for those who own investment properties.

Section 1031 of the Internal Revenue Code is one of the most underutilized sections of the tax code. When an investor sells an investment property and subsequently buys a new investment property, the investor can defer the capital gains taxes on the sale of the original investment property. The gain is “rolled over” into the new property.

Step by step overview: To begin, an investor would meet with a qualified intermediary to discuss a potential 1031 Exchange. The investor sells the investment property #1. After the close on property #1, the funds go to an escrow account, controlled by the qualified intermediary, to be held until property #2 is purchased. The qualified intermediary then transfers the funds for the purchase of Property #2.

Through a 1031 Exchange, an Investor saves the capital gains tax and can invest that money into another investment property. This is a government incentive for investors to continuously invest in real estate.

6 points to understanding the 1031 exchange requirements.

1: Like-Kind Property
The first requirement for a 1031 exchange is that the old property to be sold and the new property to be bought are like-kind. "Like-kind" relates to the use of properties. As a result, the old property as well as the new property, must be held for investment or utilized in a trade or business. Vacant land will always qualify for 1031 treatment whether it is leased or not. Furthermore commercial property may be used to purchase a rental home or a lot may be sold to buy a condo.

Additional factors to consider:
• Primary residences can never be utilized in an exchange.
• Properties to an exchange must be within the United States border. Properties located outside the United States may not be involved in the exchange.

2: 45 Day Identification Period
The Internal Revenue Code requires that the new property be identified within 45 days of the closing of the sale of the old property. The 45 days commence the day after closing and are calendar days. No extensions are allowed under any circumstances. If you have not entered into a contract by midnight of the 45th day, a list of properties must be furnished and must be specific. It must show the property address, the legal description or other means of specific identification.

Up to three potential new properties can be identified without regard to cost. If you wish to identify more than three potential replacements, the IRS limits the total value of all of the properties that you are identifying to be less than double the value of the property that you sold. This is known as the 200% rule. Accordingly, more than three properties may be identified as replacements. However, if the taxpayer exceeds the 200% limit the whole exchange may be disallowed.

It is the responsibility of the qualified intermediary to accept the list on behalf of the IRS and document the date it was received. However, no formal filing is required to be made with the IRS.

3: 180 Days To Purchase
Section 1031 requires that the purchase and closing of one or more of the new properties occur by the 180th day of the closing of the old property. The property being purchased must be one or more of the properties listed on the 45 day identification list. These time frames run concurrently, therefore when the 45 days are up the taxpayer only has 135 days remaining to close. Again there are no extensions due to title defects or otherwise. Closed means title is required to pass before the 180th day.

4: Use of a Qualified Intermediary
Sellers cannot touch the money in between the sale of their old property and the purchase of their new property. By law, the taxpayer must use an independent third party commonly known as an exchange partner and/or intermediary to handle the change. The party who serves in this role cannot be someone with whom the taxpayer has had a family relationship or alternatively a business relationship during the preceding two years. The function of the exchange partner/intermediary is to prepare the documents required by the IRS at the time of the sale of the old property and at the time of the purchase of the new property. The intermediary must hold the proceeds of the sale in a separate account until the purchase of the new property is completed. The taxpayer is entitled to the interest of these funds and must treat the interest as ordinary income during the period of escrow.

5: Title Must be Mirror Image
Section 1031 requires that the taxpayer listed on the old property be the same taxpayer listed on the new property. If you and your wife are married and sell the old property than you and your wife must also be on the title to the new property. If a trust or corporation is in title to the old property that same trust or corporation must be on title to the new property.

6: Reinvest Equal or Greater Amount
In order to defer 100% of the tax on the gain of the sale of old property, the new property must be of equal or greater value. There are actually two requirements within this rule. First, the new property has to be of greater or equal value of the one which is sold. Secondly, all of the cash profits must be reinvested.

In reality, you may deduct closing expenses and commissions from the sale of the property being sold. If the property is being sold for $500,000.00 and the actual net amount after closing expenses is $465,000.00, the $465,000.00 is required to be spent for the replacement property.

A party who elects to do an exchange and take cash out may do so. However, any cash received will be taxed at the corresponding rate of ordinary income if held for less than one year or the capital gains tax if held for more than one year.


Want a 2nd Home in Austin? 5 Helpful Tips

Whether you're thinking about buying an investment property for steady cash flow, a vacation home for your family or a temporary home for your college-bound son or daughter, there are a few things you should consider before making the investment:

Local Market -- Both the local resale and rental markets are important factors. Are home prices on the rise, increasing the possibility of a profitable sale in the future? Is the rental market tight, causing average rent prices to go up? You'll want your rental income to be able to cover mortgage costs, taxes and expenses.

Maintenance -- When calculating costs, include routine maintenance and potential repairs. If purchasing a property to rent out, note any requirements and safety obligations for your area. If you're not the handy type or your desired property is far from your primary residence, consider hiring a property management company to handle ongoing maintenance concerns.

Insurance Costs -- Find out if you need additional disaster coverage such as flood or earthquake insurance. In general expect to pay higher insurance costs, especially if you plan on renting out the property.

Financing -- Plan on being subjected to more scrutiny than you were on your primary residence. Banks often require a higher down payment on second homes, and interest rates may be higher as well.

Tax Implications -- Make sure you understand the tax implications of owning a second property. If you plan on renting it out, you'll need to report the rental payments as income. On the other hand, operating expenses, such as insurance, utilities and repairs, may be considered deductions.

Debt-to-Income Ratio

Your debt-to-income ("DTI") ratio is a valuable number when purchasing a home, especially when financing the purchase. The easy part of DTI is what it means... the amount of debt you have vs. the amount of income you make. How is the DTI ratio used? What is an acceptable DTI ratio when purchasing a home?

Lenders look at DTI during their underwriting. It influences how much they will lend you. There are two main kinds of DTI; front-end ratio and back-end ratio. Both affect lenders' decisions.

Front-end ratio indicates the percentage of income that goes towards housing costs. The "D" in DTI stands for "Debt," but it covers more than debt, including taxes, HOA dues (if applicable), insurance, fees, and insurance premiums, all on top of the principal and interest payment.

Back-end ratio indicates the percentage of income which that goes towards all recurring debt payments, including front-end debts plus credit cards, car payment, child support, student loans, legal judgments, etc.

Currently, DTI limits are as follows:
Conventional loan limits 28/43
FHA loan limits 31/43
VA loan limits 41/41
USDA loan limits 29/41

(The first number represents the (%) limit of the front-end ratio/second number represents the (%) limit of the back-end ratio)

A couple's monthly income is $7,100 (gross monthly income or income before taxes). The couple has two cars, one car is paid off. The second car is financed with a minimum payment of $450 per month. They also use credit cards with minimum payments of $50 (total).

Considering a conventional loan, find their maximum PITI payment considering the couple's monthly income.
This question is a front-end DTI question. $7,100*28% = ~2,000

What purchase price can they afford given their monthly PITI payment? $2,000 PITI Payment = ~$310,000 purchase price

Does their total debt qualify under the conventional loan DTI limits?
$2,000 + $450 + $50 = $2,500 in total recurring debt
$2,500/43% = ~$5,814 They do pass the DTI back-end limit as their monthly income of $7,100 is above $5,814.
$7,100*43% = ~$3,050 Again, they do pass the DTI back-end limit as the monthly debt of $2,500 is below $3,050.