WEALTH BUILDING THROUGH REAL ESTATE EQUITY AND 1031 EXCHANGES

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

2 thoughts on “WEALTH BUILDING THROUGH REAL ESTATE EQUITY AND 1031 EXCHANGES”

  1. I own 4 investment condos in Anaheim Hills CA. Their retail value is $1.8 million and I owe $800k. I am realizing only $1,500 per month income collectively. I am 65 and wish to retire. I want to 1031 the 4 condos for an income producing property. My realtor is confident each condo will sell within 6 weeks. Considering escrow periods I believe I can qualify all 4 condos into one 1031. What types of property should I consider to maximize income?

    1. It looks like you are achieving less then a 1% return on your investments with $18k annually on a value of $1,8m; you didn’t indicate if it was NNN, but that’s not the point. What may be tricky here is all the condos closing escrow within the same timely period if you want to pool into one/two bigger investments. You should be in a good position to restructure your equity and debt as you debt will be less then 50% of your new purchase and lots easier to finance and replace your debt. With that said;you are in a great position to buy a NNN Leased Investment that should generate about $108k annually and your debt service on the $800k should fall the range of approximately $50k leaving you with approximately $58k in annual NET Income. WHAT TO PURCHASE? That’s going to be predicated on several things;do you want to stay involved with managing or do you want little to no responsibilities? There is always a calculated risk with Real Estate and at a certain point it becomes a judgment call and business decision as to what you actually purchase. I am happy to discuss with you the pros and cons of investment types if you want to get some feedback based on my experience. Good planning is critical; especially considering the stringent time frames poised in a 45 day 1031 Exchange process. Remember you can buy almost anything that is not your personal residence; that is real property. Units, Mini-storage, NNN leased Investments, Strip Centers, Ground leased land, Office, Industrial Warehouse,etc, Thanks for contacting me and I hope I have helped you somewhat? —Annette

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Annette Cooper, Top Ten Keegan & Coppin Commercial Real Estate Agents List, is based in Santa Rosa, CA specializes in 1031 Exchanges.