“In America there are two tax systems; one for the informed and one for the uniformed. Both systems are legal.” – Justice Learned Hand
Take a look at that quote at the top of this article. Wow! What a powerful statement – made many decades ago by one of America’s greatest judges, Learned Hand. And he was referencing the benefits of the 1031 Exchange that President Harding had signed into law.
Today, one could understandably apply that same statement to the IRA as well, because – although it has been around since 1970 when President Gerald Ford signed ERISA (Employees Retirement Income Security Act) into law – most Americans still know little about it.
Without a doubt, the 1031 Exchange and the IRA (specifically, the Self-Directed IRA) are the two most-misunderstood and underutilized tax-relief tools available today.
And tax relief is what many of us will be looking for as April 15th rolls around. The fact is, none of us wants Uncle Sam as our silent partner … especially when he is already guaranteed a hefty slice out of your profit pie and rarely drops a crumb your way when you suffer a loss.
The 1031 Exchange
If you sold investment real estate in the year 2005, hopefully you considered the 1031 Exchange. This unique IRS regulation allows you to borrow money from Uncle Sam, interest free. (Because you don’t pay taxes, you don’t incur interest on the unpaid taxes.)
Here’s how a 1031 Exchange works:
When an investment property is sold, a gain is realized and the seller/taxpayer must cough up a 15% capital gains tax on the profits.
But … using a 1031 Exchange (the typical cost is around $750) allows the same seller/taxpayer to defer any taxes due on the profits to an undefined future date from the sale of investment property. (You don’t have to make payments or set a deadline for when you will repay the deferred taxes.)
In essence, the taxpayer is given the ability to borrow interest-free money from Uncle Sam. The tax that a taxpayer would normally owe is the “borrowing” – and the fact that there is zero interest due on those deferred dollars is the “interest-free” part. And it gets even better: You never have to pay back those “deferred tax dollars” to Uncle Sam when you die. When a taxpayer dies, his/her heirs receive real estate on a stepped-up basis (the fair market value of the real estate at the time of death). Ergo, you won’t pay any taxes either. (Though estate taxes could be due, depending on the size of your estate.)
The 1031 Exchange has long been employed as a tax-relief tool for the “informed.” Another key tax-relief tool, as I mentioned earlier, is the individual retirement account (IRA).
The Self-Directed IRA
Today in America, there are 45,000,000 IRAs – which, combined, represent trillions and trillions of dollars. Unfortunately, most American IRA holders do not utilize the full potential of this incredible tax tool. They have no clue about the versatility and greater profit potential of a Self-Directed IRA.
First, a bit about traditional IRAs …
In 2006, the traditional IRA allows a taxpayer to place up to $4,000 pretax dollars into it each year; $5,000 if the taxpayer is 50 or older. In 2008, those limits will go up to $5,000 and $6,000.
The tax-relief benefits of an IRA are twofold:
1. The dollars you place into it are tax-deferred.
2. Any earnings on those pre-tax dollars are also tax-deferred.
For example if your retirement objective is to place $4,000 into a savings account and your combined state and federal tax rate is 33%, you would need about $6,000 to net $4,000 after paying taxes on the $6,000. (33% tax rate x $6,000 = $1,999 in taxes)
If your marginal tax bracket is 25% and you only have $4,000 to invest, without the IRA you’d only be able to invest $3,000 … because you’d first have to fork over $1,000 to Uncle Sam. With the IRA, you get to invest the full $4,000. Compound the difference of investing $3,000 a year at, say, 10%, versus $4,000 a year at 10%, and the difference over the long term is huge. After 25 years, it’s a difference of $108,182!
With a Roth IRA, you use after-tax income to fund your IRA. Your investment and the earnings still grow tax-deferred. The advantage here is that your earnings and capital gains are also tax-FREE when you start withdrawing them in retirement.
Plus, with a Roth, you can access your capital contributions before retirement, after you’ve had the account for five years, without tax or penalty. That applies to your capital contributions, not your gains. You wouldn’t necessarily want to do that. You should let your retirement funds grow. But it’s nice flexibility to have in case you’re in a pinch for cash at some point.
If you are self-employed, you can choose a Simplified Employee Pension (SEP) that allows you to sock away up to 25% of your annual income, with a cap of $41,000. The SEP can represent major “tax relief.” And the beauty is that you don’t have to put 25% of your income into it each year. You can save as little as $1.00 … but if you have a great income-earning year, you can quickly build up a tidy nest egg for retirement.
The Self-Directed IRA
With a Self-Directed IRA, you can control your own traditional IRA funds, Roth funds, or SEP funds and get far greater investment liability than you could ever get by having your funds parked at a Wall Street brokerage and restricted to stocks and bonds.
With a Self-Directed IRA, you can buy all the stocks and bonds you like, but you can also buy real estate, government-guaranteed tax liens, and collateralized notes – to name just a few of the more secure, often more profitable, investments that are available to you with this amazing vehicle.
[Ed. Note: Thomas Phelan is a financial author, an active real estate investor, and the author of a new program – the “Instant Tax Relief Kit” – to help you take advantage of the tax-relief tools at your disposal.]