Building wealth 1 egg at a time

I recently had a chance to meet and have lunch with 1 of my parent’s friends from LA who are retired. They are in their early 50s. I asked them how they did it. Their answer was common to what I’ve seen amongst those who are savvy with their money and real estate investments. They were frugal and started saving 25-35% of their paycheck after they were married in their early 30s. Within 2 years, they were able to buy a small 1 bed 1 bath condo to live in. Within 2 more years they were able to buy a small house. They repeated this process over and over and over again and really capitalized on it when the real estate bubble burst. Now they have multiple rental properties and their combined net rental income grosses about 1 million a year. Even though they are retired they are still growing their wealth and still accumulating more properties. This is not a single isolated incident. It turns out that many real estate investors do the same thing.

How is this possible? It’s simple. 1^st you have to have money in order to start investing in your 1^st property. Then you wait for the equity to grow. Once it’s grown enough you can do 1 of 2 things; sell and buy (exchange) for something that costs the same or more or cash out refinance and use that money to buy another property. This is what is known as a 1031 exchange, or a 1031 delayed exchange, where 1 property or investment asset is swapped for another of the same value or greater value. This allows you to avoid the capital gains at the time of the exchange and allows your investment to continue to grow tax deferred. The latter method is a little trickier and would require the help of a tax attorney.

There isn’t a limit on the frequency and how many times that you can do a 1031 exchange. Basically, you can roll over the gain from 1 investment/property to another, and another, and another until you actually sell it for cash years later down the road at a long-term capital gain rate which is currently at 20%.

Here are a few important things you need to know in order to do a 1031 exchange.

• You need a middleman to hold onto the cash after you sell your property to use it to buy a replacement.
• You need a replacement property within 45 days of the sale or your property of equal or greater value.
• You must purchase a new property within 180 calendar days, 6 months, following the closing of the original property. An exception to this rule is if the property owner extends his tax return, in which case the 180-day window begins on the date of the extension.
• If you receive any cash from the sale, otherwise known as ‘Boot’, you will be taxed since this would be considered a gain. Here are some examples.
  • If you sold the property for $1,000,000 and the property you exchanged it for is worth $500,000, you would need to pay the capital gains tax on the $500,000 ‘boot’.
  • If you had a mortgage of $1,000,000 on the old property, but your mortgage on the new property is $950,000, you will have a $50,000 gain, ‘boot’, and will be taxed.