by Annette Cooper
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” (ask Annette about this). 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.
Copyright: Annette Cooper