Dear MSM Reader,

Building your real estate portfolio tax-free is a powerful and profitable tool…if you know how to avoid expensive traps the IRS has set for investors. In today’s issue, tax-savings expert Tom Phelan reveals a strategy for catapulting from residential to commercial investing, without the tax bite.

Trade Your Way Up to the Big Time

By Tom Phelan

In the past, we’ve shown you how you can use a tax-avoidance tool known as the 1031 Exchange to invest in bigger and bigger properties. For example, you can use it to trade a simple single-family rental home for a larger, three-unit apartment building.

Well, this is also a technique that investors use to go from residential to commercial … to the big time.

Today, I’m going to show you how to make that jump by using the 1031 Exchange to conduct a series of strategically planned "trade-ups." For example, you could trade that three-unit apartment building for a small strip mall … which you could then trade for a medical building. And so on.

Using a 1031 Exchange means you can pay NO taxes. And you can use that money as your down payment on an even larger property than would otherwise be possible. Eventually, you’ll be doing eight-figure deals and pulling in hundreds of thousands in passive income.

For example, I was a consultant for two brothers in Missouri who bought an apartment house for $1,000,000. They sold it a few years later, via a 1031 Exchange, for $2,400,000. Since they paid no taxes, they saved about $480,000.

If you’re using the proceeds from a sale to put a 20 percent down payment on your next property, an extra $480,000 means you’d be able to purchase a $7 million building instead of a $4.6 million building. After five years at a modest five percent appreciation, that $7 million property would be worth $8.9 million instead of $5.8 million. And that’s not to mention the greater cash-flow you’d be able to generate each and every month you own it.

But beware the "fine print." The IRS, while bestowing the immense power of the 1031 Exchange, has also set a number of traps. The three I’m going to tell you about here are:

• The Three-Property Rule
• The 200 Percent Rule
• The 95 Percent Rule

With a simple trade - perhaps trading one single-family rental home for another one - the 1031 Exchange process is relatively straightforward. But when your goal is to "roll up" into larger properties - like apartment houses and office buildings - that’s when it can get complicated.

The complications arise because you can’t simply sell your current property and then casually shop for your next one. In order to enjoy the tax-free benefits of a 1031 Exchange, you must follow a set of IRS guidelines.

For instance, you must declare to the world that you intend to conduct a 1031 Exchange before you sell the first property. Then you must identify, in writing, the specific property you intend to purchase with your tax-free proceeds. You can actually identify several potential properties that you will choose from … if you adhere to those IRS guidelines.

And that is where our three pesky rules come into play.

The Three-Property Rule

This rule - the best-known of the three - was established in an attempt to prevent real estate investors from identifying their potential properties on a wholesale basis (e.g., "All properties located in Chicago"). It states that a taxpayer may identify up to three replacement properties of any value, and may acquire one or all three of those properties without restriction.

The investor is not obligated to buy the second or third replacement properties … but he can. That’s why identifying two properties is better than identifying one. And identifying three is better than identifying two. By identifying three replacement properties, you have two back-ups in the event your first choice bombs.

But that’s not the end of the story.

Contrary to what most investors and realtors believe, three is not the limit. You may actually identify as many properties as you wish. However, if the number exceeds three, you enter a whole new arena of 1031 Exchanging. That’s why you should never flippantly provide final identification lists of more than three replacement properties.

Identifying more than three replacement properties involves a strategy. Careful planning with an intermediary is highly recommended.

The 200 Percent Rule

If you do decide to identify more than three replacement properties, you run into the 200 Percent Rule.

In a nutshell, the 200 Percent Rule states that a taxpayer may identify more than three replacement properties … provided theaggregate fair market value of all identified replacement propertiesdoes not exceed 200 percent (double) the fair market value (FMV) of all the relinquished properties.

The FMV of the relinquished properties is established on the day the properties are transferred to the buyer/exchanger. The FMV of the replacement properties is established on day 45 of the identification period.

For example, if the sale price of the relinquished property is $150,000 and the exchanger wants to identify more than three replacement properties, the total value of the replacement properties cannot exceed $300,000 (200 percent) of the value of the relinquished property.

Any aggregate value for four or more replacement properties under $300,000 is okay.

Any aggregate value for four or more replacement properties over $300,000 is NOT okay and triggers the 95 Percent Rule.

(I don’t know why the IRS came up with that "95 percent" figure. It might as well have been 100 percent.)

The 95 Percent Rule

Simply put, this rule states that if both the Three-Property Rule and the 200 Percent Rule are exceeded (i.e., four or more replacement properties are identified and the aggregate value exceeds 200 percent of the value of the relinquished property), then the taxpayer must close on at least 95 percent of the aggregate fair market value of all properties identified before the end of the replacement period (180 days from the close of the relinquished property).

For purposes of the 95 Percent Rule, the FMV is determined on the date a property is received or on the 180th day for those properties not received.

The Consequences of Not Following the Rules

So what happens if you don’t abide by these rules? Your 1031 Exchange FAILS. Do not pass Go. Do not collect 15 to 35 percent of FREE MONEY to grow your wealth. You lose.

In a heartbreaking example of a failed 1031 Exchange, two partners paid $600,000 for mini-storage units and sold them for $1,200,000. A $600,000 profit. Against my advice, the partners did not follow proper 1031 Exchange protocol. As a result, they had to pay 20 percent capital gains tax - an unnecessary $120,000. Ouch!

The power of the 1031 Exchange is easy to see - and it can be easy to take advantage of … if you follow the rules.

[Ed. Note: Tom Phelan is a leading real estate tax-loophole expert. He travels across the country, educating CPAs, realtors, lawyers, mortgage brokers, and individuals about the benefits of 1031 Exchanges and Self-Directed IRAs. Tom is also the co-author of ETR’s 1031 Exchange Program]

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Use Property and Tax Rolls to Uncover Untapped Potential

Besides the basic sales and tax data on the property, some county property tax records will include other helpful information, such as zoning information. You might find a property that appears to be a single-family residence is actually zoned for multi-unit occupancy, or may even have dual commercial/residential status. This kind of information can be a great help.

For example, and investment partner and I once bid on an 8-unit residential property. It was a good deal as a residential property, but the fact that it also had commercial zoning added the possibility of eventually moving one of our growing businesses into the building. That helped limit our risk on the deal and increase our income possibilities.

[Ed Note: Main Street Millionaire is a program designed to take you from your first deal through your step-by-step system on how to purchase cash-flow properties below market value and use creative financing techniques to close the deals with the least amount of expense, time, and risk.]