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1031 and Capital Gain

The equity market is trading mostly sideway after one of the biggest weeks of earning reports, FOMC announcements, and a somewhat mild end-of-month rebalancing. As expected, the Fed is “not even thinking about thinking” to taper asset purchase / QE to hold rates near zero, even though we have seen one of the largest GDP print in history at 6.4% for the 1st quarter. US is going through an inflation and growth cycle with strong demand for goods and services as we emerge out of the COVID lockdown. Both the equity and real estate markets are doing well, but we begin to see warning signs from China’s Purchasing Manager Index, which is an early signal for the economy. China was the first country to recover from the recession, and it begins to contract for the rest of 2021. The US will likely follow the same pattern toward late summer.

On a personal note, it is great to get an extension to file the tax return by 17 May and have more time to strategize a tax plan for 2021. Personally, I am thinking about how to reduce my capital gain exposure because I am selling two speculative / development land for a nice profit. There are several strategies available, and I’d like to share my thoughts.

There is 1031 exchange. The IRS allows you to defer paying capital gain taxes when you sell an investment property and reinvest the proceeds from the sale. You can participate in a like-kind exchange from an investment property to another type (e.g. residential to commercial, vice versa) as long as it is held for minimum of 2 years and not for personal use. The mechanics of 1031 is too long to explain in a newsletter and you can read about the rules on this article. The biggest hurdle for the real estate investor is to meet the timeline to identify and close on the replacement property. You have exactly 180 days from the sale date to close on the purchase, and in today’s tight inventory, it is extremely difficult and easily baited to overpay on the purchase.

If you are like me, what do you do if you need to defer capital gain from real estate? If you can’t find a replacement property, you can also invest with a sponsor in a tenant-in-common (TIC). I would say it is uncommon for sponsors to accept 1031 investment because the legal documents are much more complicated than typical syndications, and the timing is difficult to align. There is also more liability for you since you may be required to sign loan documents and become a loan guarantor. If you are contributing a large investment, you can invest as a key principal (KP) and take a slice of the general partnership equity. If you need more information, let's schedule a time to talk.

An important point to keep in mind, you may have to recapture the depreciation. Depreciation is the cost of an investment property for wear and tear, and it typically follows a straight-line 27.5 years for residential properties and 39 years for commercial properties. The amount you already depreciated will increase your taxable income and therefore reduce your net sales proceed.

There are other tax strategies and it’s too long to cover here; let’s have a chat if you need some ideas. Biden’s tax plan may bump your capital gain to 39% for that one year when you sell a property, even though your regular W2 and passive income are normally below the $1M threshold. Be sure to consult with a tax professional as tax laws continually change. Remember, it is not how much you make but how much you keep.

Have a great weekend! Invest with Confidence.

Henry Yuen Sharpe Investor Group Want to invest for passive income? Click here


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