Greg and Peter are brothers who have each inherited some money. After the relevant estate and/or inheritance taxes, they each received $160,000. They each want to invest in real estate, but they disagree on the strategy. They both have full-time careers, so their strategies need to account for those obligations as well. Greg plans to buy something to fix and then flip, hopefully for a profit. Peter would like to buy something to rehab and then rent. Working together, they find two homes in the same neighborhood, and complete their acquisitions approximately 3 months after receiving their inherited funds, each spending $160,000. They immediately commence making repairs and upgrades in the spare time. After about 10 weeks, they have both completed their rehab work, and have each spent $45,000 in the process. Both Greg and Peter now have $205,000 invested into their respective properties. This number constitutes their basis in the property for determining taxation at a time of future sale of the property.
Greg believes that he can sell his property for $225,000, earning him a $20,000 profit ($12,150 after brokerage commissions and transfer taxes). To compound his tax burdens, because Greg has owned the property for less than one year, he will be subject to short-term capital gains taxes, which are equal to his highest marginal income tax rate. Peter plans to hold his property and is confident that he can rent his property for $1,600 per month, or $19,200 for the first year.
From the date Greg purchased his property until the date he sold it was a grand total of six months. When Greg sold his fix-and-flip property, he was introduced to the buyer by the buyer’s real estate agent. Thus, he will be paying a 3% fee to the broker, as well as state and federal taxes on his profits:
|Brokerage Commission||($225,000 x 3%)||$6,750|
|State R/E Transfer Taxes||(estimated)||$1,000|
|Federal Short-term Calculation of the difference between the sales price of the relinquished property less selling expenses and less the adjusted basis of the relinquished property. Capital Gain Tax||($12,150 x 35%)||$4,252|
|State Short-term Calculation of the difference between the sales price of the relinquished property less selling expenses and less the adjusted basis of the relinquished property. Capital Gain s Tax||(estimated 6%)||$729|
| || || |
|Net cash after taxes and expenses|| ||$212,168|
| ||(Total Tax & Expense Loss 5.7%)|| |
|Net profit after taxes and expenses||($212,168 - $205,000)||$7,168|
|Return on Investment||($7,168/$205,000)||3.5%|
Peter listed his property for rent, and the new tenant moved in on the same day that Greg sold his property. Peter’s tenant will be paying $1,900 month, or $22,800 for the year. Peter’s tax situation at the end of the year is a little different:
|Federal Income Tax||($19,200 x 35%)||$6,720|
|State Income Tax||(estimated 6%)||$1,152|
|Total Taxes|| ||$7,872|
|Total estimated tax owed||($19,200 - $7,872)||$11,238|
|Return on Investment||($11,328/$205,000)||5.5%|
In our current example, it took Greg three months to find and buy the first property. It then took him six months to make the repairs and sell it, for a total investment cycle of 9 months. If Greg is aggressive, he can accomplish four of these fix-and-and flip transactions in three years:
|Transaction 1:|| |
|Net after commission/taxes||$212,168|
| || |
|Transaction 2:|| |
|Net after commission/taxes||$219,719|
| || |
|Transaction 3:|| |
|Net after commission/taxes||$227,263|
| || |
|Transaction 4:|| |
|Net after commission/taxes||$234,807|
|3-year total profits||$29,807|
In three years of fixing and flipping houses, Greg has netted a total of $29,807 in income. In this same time period, Peter has rented his property for $19,200 per year for the three years, netting $11,328 per year or $33,984, about 14% more than Greg netted.
Peter is now considering selling his property as part of a Section Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange . Historically, the national average for real estate appreciation is about 3.8% per year. Thus, Peter expects to sell his original investment property for about $250,000 (which is comparable to the value of Greg’s last sale at $249,000). If Peter sells his property outright, he can expect to pay taxes as follows:
Peter’s tax advisor has explained the value of an IRC Section 1031 tax-deferred exchange. Peter now knows that he can effectively defer recognition of $13,410 in state and federal taxes by structuring his transaction as part of a 1031 exchange. Accordingly, upon the sale of the property, the exchange proceeds will be sent directly to Peter’s qualified intermediary (“QI”) to be held until the purchase of his replacement property.
Within 45 days after the closing on the sale, Peter properly identified his replacement property. (More information about identification and receipt of replacement properties can be found at Rules for Identification and Receipt of Replacement Property.) Closing on his replacement property acquisition occurred well within the 180-day exchange period, utilizing the exchange proceeds held by the QI.
Greg spent much of his free time over the past three years managing the upgrades and renovations at four fix-and-flip properties. Three years on, Greg has limited options with his property. He cannot currently participate in a 1031 exchange like Peter. He could continue his path of fix-and-flip, spending much of his free time managing the improvements on each new property. He could also consider changing to Peter’s strategy and renting his current property.
During the same three years, Peter enjoyed the relatively passive income afforded by his rental property, earning about 14% more income in the process. At the same time, the net value of the real estate that the two brothers held at the end of the four years was virtually identical.
Learn the step-by-step processes involved in completing a tax-deferred exchange, which you may review with your tax and legal advisors.