Check Tax-Deferred Sale Rules Before You Sell
QUESTION: Last month my partner and I sold our business property for a net profit of about $180,000. But I recently read in your articles about tax-deferred exchanges. As we want to acquire land on which to construct a new building, how can we avoid paying tax on our profit?
ANSWER: If you have not yet closed the sale, you may be able to convert your sale into a tax-deferred exchange. But it is too late to defer tax if you have already completed the sale.
A tax-deferred IRC 1031 exchange means that you trade your property for the one you want to acquire, thus avoiding tax because the transaction is viewed as one continuous investment. An alternative is to make a Starker “delayed” exchange, as authorized by IRC 1031(a)(3).
That means you can sell your property and have the proceeds held by a third-party intermediary, while you take up to 45 days to designate the property you want to acquire and up to 180 days to complete the acquisition.
Run-Down Rentals Are a Good Investment
Q: What do you think is the best type of property to buy for investment? I used to think apartments were good investments, but a friend who owns apartments is constantly complaining about his ungrateful tenants and how his building isn’t appreciating in market value. What kind of property do you like for investment?
A: I agree with your friend that many apartment buildings are not great investments because of management headaches and the lack of much market value appreciation.
My preference is to acquire run-down, single-family rental houses which can be upgraded to increase their market value. Frankly, any type of property which can be renovated to increase its market value by more than the improvement cost can be a profitable investment.
Disadvantages of Income Property
Q: You are always so enthusiastic about investing in real estate, especially single-family rental houses. But the tax benefits and inflation hedge sound too good. Aren’t there some disadvantages?
A: Yes. Management of income properties, especially apartments, stores and offices, requires time and skill.
Handling unpleasant tenants can be a trying experience. Renting vacancies in a slow market can be difficult. Emergencies, such as broken water heaters, never happen at 9 a.m. on weekdays when a plumber is easy to find, but usually at 9 p.m. on a weekend. And the never-ending task of endorsing those nice rent checks can be very tiring. But all-in-all, I know of no better investment. If you find one, please let us know.
Small Motel a Loser as Investment Tool
Q: About three years ago, my wife and I sold our home, used that $125,000 old folks tax exemption for our profits, and bought a 22-unit motel.
We worked there day and night, never taking a vacation because we couldn’t get anyone to manage it so we could take a few days off.
Unknown to us, before we bought the only nice motel in a modest-size town, Holiday Inn was planning to build a fancy big new hotel just down the interstate highway from us.
When it was finished, they took almost all our business and we had to reduce our rates to keep going. A few months ago, we were lucky to sell out at a loss of over $100,000. Please warn your readers real estate isn’t always profitable.
A: Thank you for sharing your sad experience. Longtime readers of this column know that motels, hotels, boarding houses, bed and breakfast inns and other labor-intensive acquisitions are real estate-oriented businesses.
They definitely are not real estate investments, as are rental houses, apartments, shopping centers and office buildings. I hope your situation will help others from making the same mistake.
Real Estate Profits Come When You Sell
Q: About six years ago, my husband and I bought a 12-unit apartment building. We have a wonderful resident manager who handles most of the management. However, we are always putting money into this building. On paper, we should be netting about $450 per month. But some extraordinary expense seems to eat into our modest profit every month.
The only thing we really like about this investment is the tax shelter it gives us on our income tax returns. We are considering selling this building. A local realtor showed us how we can net over $250,000 profit. Although we realize we will have to pay tax on our profit, since we aren’t making any money on the building operation do you think we should sell?
A: As you are discovering, real estate profits occur when you sell or trade property rather than while you own the investment. During ownership, most investors are lucky to break even on the cash flow. However, the income tax savings from the depreciation tax shelter help make up for the lack of cash earnings.
Unless you think the apartment building will appreciate substantially in the next few years, taking your profit now by selling might be the wise thing to do. If you want to acquire another, perhaps larger, building, you can make an IRC 1031 tax-deferred exchange to avoid the tax erosion of paying tax on your profit.
