How I Beat Economic Armageddon Using a 1031 Exchange
This guest article was written by Shilpan of Street Smart Finance, Common Sense Personal Finance.
Armageddon is viewed as a spiritual battle or struggle in the present age between the forces of good, i.e. righteousness, purity and virtue, and the forces of evil. Well, my battle wasn’t spiritual, but it certainly was righteous as it involved saving hard-earned money from the hands of our wasteful government.
Let me end the suspense here. It all began when I wrote an email to Sam asking if I can write an article for Financial Samurai. I wanted to write about why most people can’t retire early. Soon I received a samurai like response from Sam, “Maybe your $500k in tax-free profit in the depths of Armageddon? How anybody can make money anytime and the boon of real estate as a great tax shelter for singles and couples?” How can I say no to the guy who has uncanny ability to find catchy titles?
Let’s rewind back to 2004. The commercial real estate — especially hotels — market was doing well. Lehman was still considered a major financial institution. I bid on a Comfort Inn that was owned by the Laselle bank. This hotel was doing well, but the owner recently refinanced it, took over a million dollars cash out and happily handed the property back to the bank. It was ridiculously easy to screw banks back then.
I knew that hotel required a few hundred thousands in improvements. But, I calculated that in the price that I bid to make sure that I can run it profitably from day one, should I get to buy it. I knew that there were many bidders, so my hopes weren’t too high.
Luck knocked on my doors
This hotel generated most of its revenue in summer months. I renovated the property and increased ADR (Average Daily Rate) to capitalize on the improvements. As expected, hotel revenue climbed steadily for the first three years in a row. And then something happened. Do you remember that gas prices skyrocketed in the summer of 2008? To make things worst, my hotel depended heavily on loyal seniors traveling from the mid west to Florida during the summer months. Well, they stopped making trips to the sunny state.
As I was contemplating ways to cut spending amid revenue short fall, a gentleman offered me $2.4 million for the hotel. I found out that he had to invest his proceedings from another real estate transaction using 1031 exchange to avoid paying a handsome amount to Uncle Sam.
I figured the timing was ripe as my hotel revenue was sliding while this gentleman needed to invest in another similar, commercial real estate in 45 days. So, he was extremely motivated to complete this deal.
How I beat the Armageddon
As I was feeling a sigh of relief after selling the hotel on the day Lehman Brothers collapsed, my accountant advised me that I will owe about $110,000 in capital gains taxes ($545,000 profit plus $194,000 in depreciation at 15%) . Ouch! That was a shocker for sure.
Since I heard a great deal about the buyer who exercised 1031 exchange vehicle to complete the transaction, I quickly searched for the term 1031 exchange to find ways to betray Uncle Sam.
I firmly believe that American tax code is written by the landlords. There is no tax shelter available for the windfall stock profits, but there is a powerful tax shelter, 1031 exchange, for real estate owners to avoid paying any taxes on the capital gains.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain. — 1031.org
As long as you can find a like kind real estate investment within 45 days of selling your real estate, you can beat the Armageddon. You have to find a qualified intermediary company to facilitate the transaction. These agencies are qualified by the treasury to facilitate the entire 1031 exchange process. You have to pay a small fee, but you are saving thousands or hundred of thousands in capital gains by participating in 1031 exchange process.
I found a shopping center and commercial land at a bargain due to the worst recession we were in the late 2008. The only caveat of the 1031 exchange is that you have to follow 45 strict timeline to enter into another like kind investment. Fortunately, I did find these investments after 30 days.
Uncle Sam is definitely not happy with those who betrays him, but you have to do what is best for your money. This is exactly why I think that the “Buffett Rule” won’t work unless we get rid of the progressive tax system and adopt fair tax. Do you agree?
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