1031
Exchanges
WEALTH BUILDING THROUGH CREATING
REAL ESTATE EQUITY AND 1031 EXCHANGES
I thought this would be a great time to focus on how we can build up equity in real estate and legally avoid paying capital gain taxes to Uncle Sam. I'm talking about prudent investing in commercial real estate and using the
1031 Exchange process. Professional investors have been taking advantage of this tax saving, wealth building vehicle for years.
I'm not going to cover every aspect of the 1031 Exchange process, but I do want to provide a comprehensive overview of the basic practice. I know there are a number of people who are confused by exactly what this process is, and are reluctant to take advantage of it. Remember, this only applies to commercial or income producing property. It is not applicable to your personal residence. A 1031 Exchange property can apply to raw land, residential rental houses, office buildings, ranches or farms, apartment buildings, or industrial properties.
The basic requirements to meet the 1031 Exchange guidelines are fundamentally very simple. From the day
you close escrow and sell your income property, you have 45 days to nominate three like-kind properties for purchase. You have another 4.5 months to complete the purchase of one of the properties you nominated.
You have six months from the day you closed escrow on the sale of your original property to successfully meet
the 1031 Exchange requirement for the IRS. I must caution you that the IRS is quite persnickety about that
six month rule. It isn't six months and a day.
If your deadline falls on a Sunday, closing the Monday afterward would disqualify your exchange and you would be responsible for the tax implications. (The IRS isn't noted for their sense of humor.) In addition to the six month rule,
the IRS also requires that you acquire replacement property of equal or greater value than the property you sold. Proceeds from the sale of the relinquished property must be used to acquire your new replacement property.
If you've owned income property for a while, have built some equity and are close to finishing your depreciation schedule, you may want to consider doing a another 1031 Exchange Maybe you're just tired of the kind of property you own and would like a different kind of investment. Maybe you're close to retirement and want to turn your business property into retirement income. Let's take a practical example and see why the 1031 Exchange process is so popular.
You sell a rental income property for $400,000. Let's say you have an existing “basis” on the property of $200,000. If you decide not to reinvest that money, you'd pay Uncle Sam about 30% of your capital gain or approximately $60,000. (And I'm not even mentioning depreciation recapture.) You would have roughly $140,000 left to invest in a new property. Assuming a 25% down payment, that $140,000 could buy you a property in the range of $560,000. Had you taken advantage of the 1031 Exchange program, you'd have the entire proceeds from the sale to invest in a new property. That $200,000 would represent the buying power to purchase a building in the range of $800,000 (25% of $800,000).
Now, let's see what happens a few years down the road. Let's assume the real estate market has appreciated 10% over the time period. In the first case scenario, the property is worth approximately $616,000. Let's assume your mortgage balance has been paid down about 5% (balance is now $400,000). You have a gain
of about $216,000 left to reinvest. In the second case scenario, using the same 10% appreciation assumption and the same 5% mortgage pay-down assumption, your property would be worth about $880,000. Your mortgage balance would be about $570,000 and you'd have a gain of approximately $310,000 left to reinvest.
I don't have to tell you that that's almost $100,000 difference in profit realized using the same amount of initial capital. It's easy to understand why this program has become so popular.
While the majority of people nominate three properties and purchase one, there are two options available.
One is called the 200% rule. This rule gives you the option to nominate any number of properties as long as the value of all your nominated properties doesn't exceed 200% of the aggregate value of the relinquished property (or properties). I had a client recently who was considering selling his business property here in
Santa Rosa and purchasing 10 residential houses in Texas that would have generated considerable cash flow.
One common misunderstanding in the 1031 Exchange process is the interpretation of the meaning of "likekind" for "likekind". If you sell raw land, you are not limited to purchasing more land. You can buy any kind of property that would be considered income producing. Typically, the property must have a legal description or street address.
I hope this simple overview has demystified some of the issues that surround the 1031Exchange process. Always review your specific situation with your accountant or tax attorney because each investment is different,
and will have different tax consequences. Next time, I'll discuss some of the mechanics involved in completing a transactions, such as reverse exchanges. If you have a specific question or would like some feedback on a particular property issue, please e-mail me and I'll do my best to answer or solve your question, or refer you to
a qualified resource. Remember, one good investment is worth a lifetime of toil.
Sales Leasing Investments
Annette Cooper
Commercial Real Estate
KEEGAN & COPPIN COMPANY, INC.
ONCOR INTERNATIONAL
Established 1976: Celebrating 32 Years of Service
Phone: 707.528.1400
Articles on this page:
by Annette Cooper
Anyone who is thinking about selling a business use or investment property and has a gain or taxable recapture may want to consider performing an IRC Section 1031 Exchange. Whether the investor’s property is owned free and clear, or encumbered, the benefits of a tax deferred exchange can be significant.
Section 1031(a)(1) provides that “no gain or loss is recognized on the exchange of property held for productive use in a trade or business, or for investment, if the property is exchanged solely for property of a “like-kind” that is to be held either for productive use in a trade or business or for investment.”
In a 1031 Exchange, sometimes called a “tax free exchange", a property owner may dispose of property and acquire another without incurring any immediate tax liability. This allows the taxpayer to keep the “earning power” of the deferred tax dollars working for him or her in another investment. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property. But in an exchange, the tax on the transaction is deferred until some time in the future, usually when the newly acquired property is sold.
A 1031 transaction, however, must be structured in such a way that it is in fact, an exchange of one property for another; rather than the sale of one property and the purchase of another. All requirements of Section 1031 and other sections of the Internal Revenue Code must be carefully met for a valid exchange. Further, the application of Section 1031 to a particular transaction or property can only be determined after careful study of a taxpayer’s particular circumstances and an analysis by his or her tax advisor, attorney, real estate agent and intermediary.
Investment Grade Tenants
With the growing market of 1031 transactions, many buyers are turning their attention to single tenant, triple net properties for their replacement assets. One of the main reasons is the security of an investment grade,
single tenant asset.
We focus primarily on investment grade tenants, as defined by the ratings agencies, Standard & Poors and Moody’s. We concentrate on investment grade companies due to their financial strength. As one might speculate, the stronger the tenant; the less likelihood of default or bankruptcy. The credit of the tenant affects many different aspects of an investment, including long term lease security, possible financing and asset liquidity.
Who Should Consider a 1031 Exchange?
Northern California
