A key tool for long-term real estate investors is found in Section 1031 of the U.S. Tax Code.  It is the taxdeferred exchange, also known called a like-kind or 1031 exchange.  What makes a tax-deferred exchange valuable?  With a tax-deferred exchange, you are able to dispose of a property that has appreciated and re-invest in a property or properties with better investment potential.  You can also re-leverage (spread around your equity) by acquiring two or more other properties.  With either objective, you can put off paying federal taxes on the gains until later.  

With capital gains taxes currently at very low levels, in recent years some investors have chosen, instead, to pay tax on the gains.  Why?  For one thing, they were concerned that gains tax rates may be higher in the future should Congress decide to close the current budget deficit by increasing taxes.  Another reason is that during the last  years of the hot market it was tough to find suitable replacement properties.  Provided that the property has been held for at least a year, gain from the sale is taxed at capital gains rates, generally 15%.   However, to the extent depreciation has been taken, which most real estate investors will have done, gains are taxed at a maximum rate of 25%.

With ample replacement properties to be found, we should see a reinvigorated demand for 1031 exchanges, provided the rules stay the same.  With that in mind, let’s review how a tax-deferred exchange works. The rules provide that gains realized on the exchange of property that has been held for productive use in a trade or business, or for investment, for other like-kind” property is deferred.  That means the gain is not includible on your current year’s tax return.  In the case of real estate, virtually any type of U.S. investment real estate can be exchanged for any other type of U.S. investment real estate.  Personal use property, such as a second or vacation home, does not qualify. 

In practice, deferred exchanges of residential rental properties typically are three-step transactions. The property being disposed of (the “relinquished property”) is sold to a second party, with the sale proceeds held by an intermediary.  The seller then has 45 days after the sale of the old property to identify a new property or properties.  The acquisition must take place at the earlier of 180 days from the settlement date or the due date for the federal income tax return from the year in which the property is sold (extension included).  The “replacement property” can also be bought in advance of selling the old property and special rules apply to such “reverse exchanges.” 

In any case, the replacement property must be specifically identified in exchange documents.  It is essential that a qualified intermediary be used to facilitate the transaction.  Your Realtor can probably assist in finding one or refer to www.1031.org, the web site of the Federal of Exchange Accomodators, the professional trade association for intermediaries.  Like-kind exchanges allow investors to re-leverage by exchanging property with a lot of equity for two or three others.  The maximum is generally three of any market value.  However, more are permitted provided they do not exceed 200% of the aggregate market value of all the relinquished properties. 

Exchanges also present an opportunity for an investor to shift the location of investment properties, either to a more promising area for appreciation or to a geographical area that is closer to the investor’s home, for instance, as a convenience in managing the property.  Understand that with a tax-deferred exchange, the tax basis of the new property will be the basis of the old property, which will probably reflect depreciation deductions.  That will also limit the depreciation deductions on the new property.  We do want to emphasize that a tax deferred exchange cannot be used for a vacation or second home whose purpose has been personal use.

Currently, more than 30% of American households are renters.  Due to foreclosures, tougher financing rules and a fear of the market among some who might otherwise own homes, that percentage is growing, reversing a trend toward wider homeownership.  Whatever the reasons, owning investment properties and multi-unit buildings works:  there are tens of millions of American households who need properties to rent.

If you own your own home, you are already a real estate investor. For some, that is enough, but others want more.  How do you go about acquiring investment property?  At a time when the demand for rental properties is growing, the rules for financing them are getting more restrictive.  With bad loans still reverberating throughout the financial system, lenders are sensitive to any loan that appears higher risk and, unfortunately, real estate investment properties are viewed as being just that.  One of the best strategies in recent years has been to use your residence as the entry into the next level of real estate investing.  Most people who purchase another home usually sell their current one in order to move up to a larger one. 

Instead, you could simply keep the first home as a rental property. Many investors have patiently converted a succession of residences to investment homes, steadily accumulating properties whose rents serve as an annuity!  This can still work, but like virtually every mortgage financing arrangement, has become more difficult in the current restrictive lending environment.  

Fannie Mae has added new requirements: you will have to have 30% equity before you can count part (75%) of the rental income toward offsetting the mortgage payment.  If converting your home to a rental is a possibility, advance planning is extremely important.  Before you start looking for a new home you need to free up any available equity from the old home for your downpayment and closing costs, as an owner-occupant.  Understand that, as a first-time investor, you will be required to maintain substantial reserves, as much as 12 months worth of mortgage payments.  If your current home has little equity or is not a viable rental possibility, there is investor financing.  Like most mortgage programs, it comes with greater restrictions and higher costs than in the past.  With investor financing you will pay more than owner/occupants and the rules have gotten and are getting even tougher if you want to get in with a minimum downpayment. 

Freddie Mac has announced that, as of August 8, it will only purchase loans on investment properties where the owner has no more than four other units. Previously, the limit had been ten.  Mortgage insurers are pulling away from writing insurance on investment properties, limiting or eliminating programs that allow greater than 80% loan-to-value ratios.  Currently, only Genworth and RMIC of the big four MI companies will insure investor purchases up to 90% LTV, and the minimum credit score is 720.  A major caveat: though Genworth and RMIC will insure investor loans to a maximum of 90% LTV, even they will not insure these purchases if the property is located in a “declining market.”