What is a 1031 Exchange?
The Internal Revenue Code Section 1031 provides a powerful strategy for selling appreciated commercial real estate and is an excellent vehicle for preserving and growing real estate wealth. It allows for the deferral of long term capital gains taxes (20%), Obama Care capital gains taxes (3.8%), the deferral of depreciation recapture (25%) and state taxes (6% to 9%) on the sale of real estate held for investment or held by a business for use in the business. The primary advantage of the 1031 exchange is that, because taxes are not recognized (paid) on the sale, the investor can significantly increase his buying power and leverage in the newly acquired property.
Reasons for Utilizing the Benefits of a 1031 Exchange
Because investment objectives or personal situations change over time an investor may want to transfer his real estate holdings to a different asset class or a different region of the country. They may also want less management responsibilities or to upgrade their tenant mix. For example, Mr. Critelli owns a 100 unit apartment building in Orlando, FL for the last 10 years. His daughter, who he is very close to, is now married with children and living in Cleveland, OH. Mr. Critelli is tired or the constant tenant issues of his 100 unit apartment building and is thinking of selling and moving to Cleveland to be near his daughter and grandchildren. His financial planner assures him that a 1031 exchange is suited for his retirement objectives. Mr. Critelli is convinced that the industrial real estate market in Cleveland is the way to go. His broker from Madison & Hoyt searches commercial real estate listings in Cleveland for NNN investments and finds him a sale leaseback opportunity that has 12 years remaining on a triple net (NNN) lease with a national credit tenant. Through the 1031 exchange process, Mr. Critelli is able to sell his apartment in Orlando and transfer all his equity into the industrial investment without having to pay any taxes!
An Illustration: Advantage of a 1031 Exchange
Peter the investor decides to sell a shopping center that he has owned as an investment for 10 years. It was originally purchased for $500,000, which is now worth $1,000,000. His real estate broker from Madison & Hoyt has recommended that he engage in a tax deferred exchange, thereby deferring payment on capital gains taxes. He finds Peter a shopping center valued at $2,000,000 for his Replacement Property. Peter’s CPA calculates that $200,000 in depreciation have been taken over the last 10 years along with $25,000 of capital improvements. The closing costs of selling the shopping center are estimated to be $150,000.
Step One-Determine the Cost Basis Typical Sale 1031 Sale
Original Purchase Price $500,000 $500,000
+ Capital Improvements 25,000 25,000
- Depreciation Taken 200,000 200,000
Adjusted Cost Basis $325,000 $325,000
Step Two-Determine Gain on Sale
Selling Price $1,000,000 $1,000,000
- Costs of Sale 150,000 150,000
- Adjusted Basis 325,000 325,000
Gain on Sale $525,000 $525,000
Step Three-Determine Taxes
Depreciation Recapture (25% x $200,000) $50,000 N/A
Capital Gain (20% x $325,000) $65,000 N/A
Obama Care Capital Gain Tax (3.8% x $325,000) $12,350 N/A
Total Federal Taxes $127,350 N/A
Step Four-Determine Sales Proceeds
Sales Price $1,000,000 $1,000,000
- Costs of Sale 150,000 150,000
- Mortgage Balance 350,000 350,000
Sales Proceeds (Before Tax) $500,000 $500,000
- Taxes on Sale 127,350 N/A
Sales Proceeds (After Tax) $372,650 $500,000
Proposed Acquisition: $1,490,600 $2,000,000
Based on a 25% Equity Investment (75%LTV)
The typical sale results in cash to seller of $372,650 after paying $127,350 in taxes. On the other hand, under the 1031 exchange scenario, the deferred taxes ($127,350) are used to leverage (increase) the investment in the replacement property by $509,400.
The main disadvantage of a 1031 Exchange is that the basis of the replacement property will be lowered by the amount of gain deferred on the sale of the relinquished property.
Steps of a 1031 Exchange
Step One: Before the Selling the Relinquished Property
Contact Madison & Hoyt for advice to determine whether a 1031 Tax Exchange is beneficial to your particular circumstance. For your convenience, we will even arrange a conference call or meeting with your financial or legal consultants. Once the determination is made that a 1031 is beneficial, Madison & Hoyt will place your property on the market for sale and start the search for a suitable replacement property based on your requirements. At the same time Madison & Hoyt will provide you with a list of Qualified Intermediaries that will coordinate with you to ensure compliance with all the 1031 exchange requirements.
Step Two: Selling the Relinquished Property
Through the successful efforts of Madison & Hoyt marketing, a buyer has been secured. The proceeds from the sale will be wired to your Qualified Intermediary and held in an escrow account. The day after closing on the Relinquished Property is when the time clock begins (Day One)
Step Three: Identification of Replacement Property
With a time limit of 45 days to identify a new replacement property(s), Madison & Hoyt will now expedite the research and due diligence necessary for identifying a desirable replacement property. There are three rules in identifying the replacement property:
a. The Three Property Rule (most commonly used)
The Exchanger may identify up to three properties without regard to their value
Step Four: Purchase of the Replacement Property
Now that a Replacement property is identified, exchanger must close on the replacement property within 180 days following the sale of the Relinquished Property.
Basic Rules of a 1031 Exchange
1. Investment Intent. Both the property sold (Relinquished Property) and the property purchased (Replacement Property) must be held for investment or productive use in a trade or a business. None of the properties exchanged can be your personal residence, a vacation home or dealer property.
2. Time Frames. Replacement Property must be identified within 45 calendar days of the sale of the Relinquished Property and must be purchased within 180 calendar days from the sale of the Relinquished Property or the due date for your personal tax return for the taxable year in which the transfer of the Relinquished Property occurs. You do not have to close the identified property under contract in order to identify them. Remember, 1031 deadlines are firm, with no extensions to these timeframes.
3. Like-Kind. The Replacement Property must be “Like-Kind” to the Relinquished Property. Any type of real property is like kind to other real property as long as it is held for investment purposes or held for business use. For example, you can relinquish an office building and replace it with a shopping center or vacant land. Any property held for personal use and/or dealer property are not qualified for a 1031 tax exchange treatment.
4. Common Ownership. The party selling the Relinquished Property must be the same party purchasing the Replacement Property. Consequently, it is the Qualified Intermediary, a legal entity that is now your agent that legally sells the Relinquished property and buys the Replacement property on the Exchanger’s behalf. At closing of the Relinquished property, the proceeds are delivered directly to the Qualified Intermediary. The Exchanger may not take constructive receipt of the funds.
A partnership cannot change partnership interests over 50% between the relinquished property and the replacement property, since such a change would make the resultant partnership a different partnership. A strategy most used, to alleviate this situation is to dissolve the existing partnership and create a “tenants-in-common” form of ownership. Each owner could then treat his or her interest as a separate property. As tenants-in-common, each owner is considered to have an individual undivided interest in a property, and that interest can be bought or sold or placed into a 1031 Exchange without regard to the actions of the other tenants-in-common.
5. Property Value. You must purchase a property of equal or greater value to the property sold or pay tax on the difference.
6. Exchange Funds. You must use all of the cash proceeds from the sale of your Relinquished Property towards the purchase of Replacement Property. If the exchanger receives cash, notes or personal property it is classified as “boot” and is subject to taxes. If you offer Seller Financing on your Relinquished Property, you may be subject to tax as the principal is repaid.
To avoid “boot” the replacement property’s sales price, equity and mortgage amount must be equal to or greater than the relinquished property.
Types of Exchanges
1. Forward Delayed Exchanges
The most common type of exchange and which is explained in this handbook is the Forward Delayed Exchange. Accomplished when a property is sold (Relinquished Property) and a property is purchased (Replacement Property) within 180 days following the sale of the Relinquished Property. For a safe harbor Forward Delayed Exchange, the sale proceeds must be held by a Qualified Intermediary between the sale of the Relinquished Property and the subsequent purchase of the Replacement Property.
Common Misconceptions About 1031 Exchanges
* You must “exchange” one property for another simultaneously.
A one-for-one simultaneous swap need not take place. In a Forward Delayed Exchange (the most common type of exchange), property is sold (Relinquished Property) and Replacement Property is purchased (Replacement Property) within 180 days following the sale of the Relinquished Property. In a Reverse Exchange, however, the Replacement Property is purchased before the sale of the Relinquished Property.
* The property purchased has to be the same type as the property sold to meet “like-kind” requirements.
Any real property is “like-kind” to any other real property under 1031 guidelines. This means that a shopping center can be “like-kind” for raw land, and an office building can be “like-kind” for a residence that is held for investment purposes.
* The 1031 Exchange is a loophole in the tax code.
Section 1031 has been a part of the Internal Revenue Code since the inception of the Code during the 1920’s. It is a valid tax deferral strategy, which stimulates investment and is not a gimmick or loophole in the Tax Code.
* I can hold the money from the sale of my property and use it to purchase replacement property without dealing with a Qualified Intermediary. A “Qualified Intermediary” provides safe harbor protection for 1031 Exchanges. Without using a Qualified Intermediary an exchange may be reviewed by the I.R.S. and invalidated by the courts. A Qualified Intermediary must remain completely independent and cannot have been your agent (attorney, CPA, broker, etc.) in the past two years.
* If I am having difficulty with my purchase, I can extend the 1031 deadlines.
There are no extensions for either the 45 or the 180 day rules except for extraordinary events such as hurricanes, terrorist attacks and presidential orders.
* Through a 1031 Exchange, I never have to pay the capital gains taxes that would otherwise be payable.
A 1031 Exchange is a tax deferral strategy. Taxes are deferred, and the cost basis transfers from the Relinquished Property to the Replacement Property. Through continued 1031 planning, it may be possible to turn this tax deferral into tax savings.
This information is not intended to render legal or tax advice. Please consult with your attorney or CPA before making any decisions.
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