NEW YORK (TheStreet) -- Real estate remains a very popular and lucrative investment, yet many Americans fail to take advantage of a trick that could dramatically lower their tax bills on real estate profits.
According to a recent Gallup poll, more Americans chose real estate over assets such as stocks as the best long-term investment.
And real estate is proving profitable for some of the wealthiest people. According to Forbes, 23 new entrants made it the magazine's 2015 billionaires list thanks to their real estate holdings. That boosts the total number of real estate billionaires to 157, Forbes said.
Capital gains taxes can take a bit out of investors' real estate profits, however. Specifically, the federal long-term capital gain tax rate increased from 15% to 20% for Americans with modified adjusted gross income of more than $400,000 ($450,000 for married filing jointly). Many real estate gains are also hit with an additional 3.8% Net Investment Income Tax, putting the current tax rate at 23.8%, but it could rise as high as 28%.
One of the secrets to real estate investment is a little-known trick known called the "1031 exchange," something that can save more than 30% in taxes on capital gains.
"Surprisingly, many investors are not aware of this," said Michael Brady, a certified exchange specialist and vice president of New York title company Riverside Abstract and sister company Riverside 1031. "Even real estate lawyers are asking us about it."By taking advantage of the 1031 exchange rule, investors can reap big breaks on appreciated real estate assets.
"Astute investors use 1031 exchanges to diversify their portfolios, exchanging one high priced property for several smaller properties, or investing their money in regions where bargains are easier to find," Brady said.
Use of these exchanges has been increasing among professional real estate buyers. According to an early 2014 report by the National Association of Real Estate Investment Trusts, the leading authority on U.S. real estate investment trusts, the overall 1031 exchange activity level among publicly traded REITs was up. One company processed $85 billion in 1031 transactions. These exchanges are named after section §1031 of the Internal Revenue Code.
Here's how these exchanges work in practice:
You sell a property at a profit. Within 45 days, you find one or more replacement properties -- worth the same or more -- that you want to defer the money to.
From there, the taxes from the profits made from the first property can be deferred and used to invest in the next real estate investment, saving the investor a significant expense and giving him or her more capital to work with.