Capital Gains Deferral as a Wealth-Building Tool

Capital Gains Deferral as a Wealth-Building Tool

The Capital Gains Deferral as a Wealth-Building Tool Almost any form of investment must be done with after-tax dollars. The capital gain you make from real estate investing, however, is the exception. You cannot sell 100 shares of Microsoft stock in a high market and reinvest it in 100 shares of another stock without cashing out, paying the taxes due, and then buying the replacement stock with after-tax dollars.

However, in real estate you can sell (1031 exchange, explained later) an investment property and buy another using the untaxed dollars from the returns on the first investment. This ability to defer all taxes on the investment returns has made more than a few people very wealthy.

Example:
Paul is an insurance agent; he bought a triplex 10 years ago for $100,000, and its current value is $220,000. Recently, he has considered opening his own insurance office and has found a perfect office building for sale at $300,000 that he wants to buy. Paul sells his triplex under the provisions of a 1031 tax-deferred exchange and purchases the office building replacement property. He is able to fully defer any capital gains tax or recapture of depreciation. Paul operates his insurance company for 15 years and is ready to retire. He would like to move to another state and buy an income-producing investment property there. The office building’s value has grown to $500,000, and the 12-unit apartment building he would like to buy is priced at $550,000. Again, Paul uses a 1031 exchange to sell the office building, and he purchases the 12-unit apartment, completely deferring all capital gains and recapture of depreciation.

There is no limit to the number of times you can use a 1031 exchange to trade up without incurring any tax liability. The key is that current IRS regulations allow this continuing deferral on capital gains but not on any other types of increases in wealth.

The ability to defer capital gains in the now commonly known 1031 exchange was a hardfought- for right that had to been pounded out in the courts and forced upon the IRS through legislative mandate over a period of 20 to 30 years. This wealth-building tool now works extremely well, and any changes in the capital gains tax rules can only harm wealth-building tools like 1031 exchanges.