Sheltering income from taxes, also known as tax avoidance, is a legitimate and worthy pursuit. It is distinguished from tax evasion, which is the deliberate underpayment of or failure to pay taxes. There are several excellent ways to shelter income from taxes, including making contributions to certain retirement accounts, using pre-tax dollars to pay for health insurance and medical care, enrolling in a college savings account, and owning a business.
Real estate: shelter with staying power
Real estate is a substantial shelter for income, both when you buy property and later. Homeowners have long enjoyed the deduction of the mortgage interest and property taxes they pay on their primary home. However, that avenue has become less used since the passage of the Tax Cut and Jobs Act, which substantially increased the standard deduction and simultaneously limited deductions for property taxes and mortgage interest. Untouched, though, is the cherished exclusion from income of up to $250,000 ($500,000 for a married couple filing jointly) from the sale of a primary residence. To qualify as a primary residence, you must have lived in the home for at least two of the five years preceding the sale, which seems generous.
Beyond primary homeownership, the benefits of real estate may grow with the reach of your investments. A fine example is in a taxpayers' ability to defer the recognition of a capital gain when selling investment property through a 1031 Exchange.
Why do a 1031 exchange?
The best reason to structure the sale and purchase of investment property through a 1031 exchange is to defer the federal and state capital gains taxes, which are significant. The name refers to the relevant section of the IRS code. It allows an investor to sell one property and reinvest the proceeds in a similar or "like-kind" property, as long as they do not take control over the funds during the interim period. Rules govern these transactions, and a third party must facilitate the exchange to meet the hands-off requirements.
What are the potential pitfalls?
The 1031 exchange has a strict timeline and identification requirements, which means it is crucial to have a solid plan in place before you sell the original property (referred to in the transaction as the "relinquished" asset). If you fail to complete the identification of potential replacement properties within the specified 45-day window following the sale, the IRS will disallow the exchange, and the deferment of gains won't succeed.
For the same reason, the skills of the third party facilitator, known as a Qualified Intermediary, are vital. That person is key to the success of the transaction, so choosing the right one is essential. The QI must ensure that paperwork is collected and submitted within the timelines and that funds in escrow are at arms-length from the investor. The QI receives formal identification of the replacement property choices and facilitates the purchase of the final selection. They also prepare and submit the forms needed for tax filing.
Although your accountant may not serve as your Qualified Intermediary, they may be able to recommend one and can advise you on whether this strategy is appropriate for you.
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