Real Estate Investors and 1031 Exchanges
REAL ESTATE AS AN INVESTMENT TOOL
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ADVANTAGES OF A 1031 EXCHANGE
- Preservation of Equity
- Maximize Return on Investment
- Increased Cash Flow from larger properties
- Tax Deferral
A Sale Verses an Exchange
Analyze the Benefits Before Selling
The benefits of IRC Section 1031 exchanges can be tremendous! Investors are often able to defer thousands of dollars in capital gain taxes, both at federal and state levels. If the requirements of a valid 1031 exchange are met, capital gain recognition will be deferred until the taxpayer chooses to recognize it. This essentially results in a long-term, interest-free loan from the IRS.
An investment property owner sells a rental property for $400,000. The owner originally purchased the property for $200,000. There is $200,000 of debt and the property has been fully depreciated. The capital gain is approximately $350,000 (assuming 75% of the property is depreciable). If the investor does not do an exchange, federal capital gain taxes would be:
$150,000 (Depreciation Recapture) X 25%= $37,500
$200,000 (Capital Gain Balance) X 15%= $30,000
Therefore $350,000 Capital Gain Taxes Owed would equal $67,500
The State taxes owed (where applicable) would need to be added to the federal taxes due. Assuming the property owner sold in California, the following additional taxes would need to be paid:
State level (CA) 9.3%, $350,000 X 9.3%= $32,550
Therefore the Total Capital Gain Taxes (Federal and State) would be $99,050
The next comparison anaylzes the value of the new property that could be aquired in a sale versus exchange. The comparison assumes an investor makes a 25% down payment and finances 75% of the property (75% loan-to-value ratio).
(Equity) $200,000 - (Capital Gain Tax) $99,050= $100,950 (Cash to Reinvest)
Assuming a 75% Loan to Value a new property could be purchased at $403,800
(Equity) $200,000 - (Capital Gain Tax) $0= $200,000 (Cash to Reinvest)
Assuming a 75% Loan to Value a new property could be purchased at $800,000
1031 Tax Deferred Exchanges
An overview of several requirements for Tax Deferral
What is IRC Section 1031?
Section 1031 of Internal Revenue Code allows an owner of an investment property to exchange property and defer paying federal and state capital gains taxes (up to 15% Federal, 25% depreciation recapture and applicable sales taxes) if they purchase a "like-kind" property following the rules and regulations of the Internal Revenue Code. This allows investors to use ALL of the sale proceeds to leverage more valuable real estate, increase cash flow, diversify into other properties, reduce management or consolidate holdings.
What is "Like-Kind" Property?
There is some confusion regarding what type of property qualifies for a 1031 tax deferred exchange. The Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment". "Like-Kind" property can include, but is not limited to, any of the following, provided it is held for investment:
- Single Family Rental
- Commercial Property
- Raw Land
For example, raw land can be exchanged for a single family rental, or apartments, or a commercial building. Properties can be exchanged anywhere within the United States.
Does an exchange need to be simultaneous?
No, contrary to what some property owners envision, a 1031 tax deferred exchange is rarely a two party swap. Most exchanges are delayed exchanges, whereby the Exchanger has 180 days between the sale of the relinquished property and the closing of the replacement property. They must identify the potential replacement property (or properties) within 45 calendar days form closing on the relinquished property.
When is a 1031 Exchange applicable?
It is applicable whenever a property owner intends to SELL any property that is not their primary residence (and falls under the definition of "like-kind") and plans to BUY another "like-kind" property within 180 calendar days following the closing of the relinquished property.
Paramount to any exchange is a competent and experienced qualified intermediary.
Five Reasons to Exchange
Investors can meet many objectives under IRC 1031
Section 1031 tax deferred exchanges continue to increase in popularity as more investors nationwide discover the wide range of investment objectives that can be easily met through exchanging.
1. Preservation of Equity
A properly structured exchange provides real estate investors with the opportunity to defer 100% of both Federal and State capital gain taxes. This essentially equals an interest-free, no-term loan on taxes due until the property is sold for cash. Often the capital gain taxes are deferred indefinitely because many investors continue to exchange from one property to the next, dramatically increasing the value of their real estate investments with exchanges.
Many investors exchange from a property where they have a high equity position, or one that is "free and clear" into a much more valuable property. A larger property produces more cash flow and provides greater depreciation benefits, which therefore increase the investors' return on their investment.
Exchangers have a number of opportunities for diversification through exchanges. One option is to diversify into another geographic region, such as exchanging out of one apartment building in Denver, Colorado, for two additional apartments- one in Los Angeles, California, and the other in Dallas, Texas. Another diversification alternative is aquiring a different property type, such as exchanging from several residential units to a small retail strip center.
4. Management Relief
Some investors accumulate several single family rentals over the years. The on-going maintenance and management of what can be a far-reaching group of properties can be lessened by exchanging these properties for one property better suited to on-site maintenance and management. Exchanging into a single apartment complex with a resident manager is a good example of this strategy.
5. Estate Planning
Sometimes a number of families inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property Which they can either hold or sell.
Calculating Your Capital Gain
Analyze the Benefits Before You Sell
Compare the tax savings and additional purchasing power of an exchange verses a taxable sale.
1. Calculate Net Adjusted Basis
Original Purchase Price + Improvements - Depreciation = NET ADJUSTED BASIS
2. Calculate Capital Gain
Sales Price - Net Adjusted Basis - Cost of Sale = Capital Gain
3. Calculate Capital Gain Tax Due
Recaptured Depreciation (25%) + Federal Capital Gain (15%) + Sales Tax (when applicable) = Total Tax Due
4. Analyze Purchase without Exchange
Sale Price - Cost of Sale - Loan Balances = Gross Equity - Capital Gain Taxes Due = Net Equity
Net equity X 4 = Value of Property You could obtain with 25% down
5. Analyze Purchase with an Exchange
Capital Gain Taxes Due (0), Gross Equity = Net Equity
Net equity X 4 = Value of Property You could obtain with 25% down
The real power of tax deferred exchanges is not just the tax savings- it is the tremendous increase in purchasing power generaged by this tax savings. With the advantages of leverage, every dollar saved in taxes allows a real estate investor to purchase two to three times more real estate.
Many investors are suprised to discover that capital gain taxes are far higher than 15%. State taxes, which can be as high as 11% in some states, are added to the federal capital gains taxes owed. In addition, depreciation deducted over the ownership period is taxed at a rate of 25%. The net result is often a large percentage of your profits going directly to pay taxes. Under the 4th calculation, the net equity times four (assuming a 25% down payment) is the value of property you could purchase after paying al capital gain taxes. Under the 5th calculation, involving an exchange, NO TAXES ARE PAID, leaving the full purchasing power of the ENTIRE GROSS EQUITY to acquire considerably more real estate. In just one transaction, the Exchanger acquires far more investment property than a seller.
What language should be added to the contract in an exchange?
Although many Exchangers include language in their Purchase and Sale Agreement establishing their intent to perform an exchange, is NOT required by the Internal Revenue Code.
Contracts Must be Assignable
It is important, however, that the Purchase and Sale Agreements for both properties are assignable. An Exchanger should reveiw the contract to confirm that they are not prohibited from assigning their position as either a "Seller" or "Buyer" to a Qualified Intermediary.
"Last Minute" Exchanges are Possible
In most situations, a successful exchange can be accomplished as long as a qualified intermediary is contacted prior to closing. Many Exchangers and real estate agents add exchange langauage to the contract for several reasons:
- It establishes their intent to perform a 1031 tax deferred. exchange
- To notify the other party in advance of the need to assign the contract to an intermediary.
The language below is satisfactory to establish the Exchanger's intent to perform a tax deferred exchange and release the other parties from costs or liabilities as a result of the exchange:
Sale of Relinquished Property
"Buyer is aware that the Seller intends to perform an IRC Section 1031 tax deferred exchange. Seller requests Buyer's cooperation in such an exchange and agrees to hold Buyer harmless from any and all claims, costs, liabilities, or delays in time resulting form such an exchange. Buyer agrees to an assignment of this contract by the Seller".
Understanding 1031 Tax Deferred Exchange Terminology
Too many real estate investors, the "Buzz Words" often used to describe different aspects of the tax deferred exchange can be confusing. For example, doesn't something with two 'downlegs' and three 'uplegs' sound a lot mroe like a lopsided creature than an exchange transaction? Reflected below are brief descriptions of commonly used exchange technology:
Actual Receipt: Physical possession of proceeds.
Boot: "Non Like-Kind" property received; "Boot" is taxable to the extent their is a capital gain.
Cash Boot: Any proceeds actually or constructively received by the Exchanger.
Constructive Receipt: Although an investor does not have actual possession of the proceeds, they are legally entitled to the proceeds in some manner such as having the money held by an entity considered as their agent or by someone having a fiduciary relationship with them. This can create a taxable event.
Direct Deeding: Transfer of title directly from the Exchanger to Buyer and from the Seller to Exchanger after all necessary echange documents have been executed.
Exchange Agreement: The written agreement defining the transfer of the relinquished property, the subsequent receipt of the replacement property, and the restrictions on the exchange proceeds during the exchange period.
Exchange Period: The period of time in which the replacement property must be received by the Exchanger; Ends on the earlier of 180 calendar days after the relinquiched property closing or the due date for the Exchanger's tax return (If the 180th day falls after the due date of the Exchanger's tax return, an extension may be filed to be entitled to the full 180 day exchange period).
Identification Period: A maximum of 45 calendar days from the relinquished property closing to properly identify potential replacement property or properties.
Like-Kind Property: Property held for productive use in a trade or business, such as income property, or Property held for investment. It is not required that exactly the same type of property is exchanged. Therefore, not only is rental or other income property qualified, so is unimproved property that has been held as an investment. The unimproved property can be exchanged for improved property of any type, or vice versa. Also, one property may be exchanged for several, or vice versa. This means that almost any property that is not a personal residence or second home is eligible for exchange under Section 1031.
Mortgage Boot: This occurs when the Exchanger does not acquire debt that is equal to or greater than the debt that was paid off on the relinquished property sale; Referred to as "debt relief". This can create a taxable event.
Qualified Intermediary: The entity who facilitates the exchange; defined as follows: 1. Not a related party (ie. agent, attorney, broker, etc.) 2. Receives a fee 3. Receives the relinquished property the Exchanger and sells to the buyer 4. Purchases the replacement property from the seller and transfers it to the Exchanger.
Relinquished Property: Property given up by the Exchanger, referred to as the sale, 'downleg' or 'phase
Replacement Property: Property received by the Exchanger. Referred to as the purchase, 'upleg' or 'phase 2'.
This information is NOT intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.