Tax and Legal Terms
Like-Kind Exchange (1031 Exchange)
Ever wished you could swap one property for another without dealing with the taxman right away? Well, you're in luck! The 1031 Exchange, often termed the "Like-Kind Exchange," lets investors do just that. In essence, you're swapping one investment property for another and deferring the capital gains tax as well as the depreciation recapture. But, and there's always a "but", there are specific rules to follow. Dive in deeper, and you'll see why many real estate investors have this tool in their arsenal.
Qualified Intermediary (QI, 1031 Intermediary, or 1031 Custodian)
When you’re executing a 1031 Exchange, you can't just swap properties willy-nilly. Enter the Qualified Intermediary! Think of the QI as the referee in this property-swapping game. They hold onto the sales proceeds when you sell your old property and then use them to buy the new one, ensuring you don't touch the money and accidentally disqualify the exchange. These folks are crucial and often have a wealth of knowledge to share about the process.
Imputed Interest
Picture this: you lend your buddy some cash for his new venture, but you don't charge interest. The IRS, being the ever-watchful entity, could say, "Hey, you should've charged interest on that!" Then, they have the ability to tax you on this 'imaginary' interest, even if you never saw a dime. That's Imputed Interest for you. This is an objection that you may have to address when discussing seller financing terms.
Bonus Depreciation and Accelerated Depreciation
Imagine getting a head start in a marathon. That's kind of what Bonus and Accelerated Depreciation offer to property owners. Instead of spreading out your property's depreciation over decades (which can feel like watching paint dry), these tools let you claim a larger chunk of depreciation upfront. It's a tax-saving move, especially sweet in the early years of ownership. Always check with your CPA, though, as these rules can be a moving target.
Real Estate Professional Status
Wearing the badge of "Real Estate Professional Status" is like unlocking a video game's ultimate power-up for tax benefits. It means real estate isn't just a side gig for you; it's your main hustle. The IRS gives special tax advantages to folks with this status, but be warned: achieving it involves meeting specific criteria, like spending more than half of your working hours in real estate. It's not for the casual investor but, if you qualify, the rewards can be golden! One of the best benefits is being able to offset active income with passive losses from such tools as bonus depreciation.
Material Participation
If you’re unable to attain the status of real estate professional status, you still may be able to reap the benefits of passive depreciation offsetting your active income by leveraging material participation in specific investments like short term rentals. It’s a fantastic loophole that a lot of my clients, who are high income earners, have leveraged to reduce their tax burden.
Sweat Equity
You've heard of earning equity by putting money into a deal, but what about equity you earn by rolling up your sleeves? That's Sweat Equity. It's the value you add to a property by putting in your own elbow grease, whether through renovations, management, or other hands-on work. The amount of equity earned will depend on how valuable the sweat equity is perceived by the other partners in the deal, so be prepared to negotiate your worth if this is your tactic.
Corporate Veil
Picture an invisible shield around your business, protecting your personal assets from business troubles. That's the Corporate Veil. When you form an LLC or corporation, this veil is what keeps creditors from going after your personal goodies if things go south. But beware: sloppy business practices can poke holes in this shield. Keep business and personal matters separate, and that veil will remain strong.
Loss Runs
If you've ever wondered about a property's insurance claim history, you're thinking of Loss Runs. It's like a report card for a property, showing all insurance claims made over a certain period. Think of it as a history lesson, giving insurers (and you) a peek into any past problems. A clean Loss Run can be a green flag, but a spotty one? That might just raise some eyebrows. You’ll ideally get the past 5 years of loss runs when purchasing a commercial property, but you’ll often be at the mercy of whatever the seller is able to offer you.
