Maximize Returns with NNN Investments and 1031 Exchange Solutions
Understanding 1031 Exchange
Internal Revenue Code Section 1031 offers a powerful tax deferral strategy for selling appreciated commercial real estate, preserving and growing wealth. It allows deferral of long-term capital gains tax (20%), Obama Care capital gains tax (3.8%), depreciation recapture (25%), and state taxes (6-9%) on the sale of investment or business-use real estate. By deferring these taxes, investors gain significant buying power and leverage for new property acquisitions.
Benefits of Utilizing a 1031 Exchange
Investment objectives and personal situations evolve. A 1031 exchange allows investors to strategically transfer real estate holdings to different asset classes or regions, reduce management responsibilities, or improve tenant mix without immediate tax implications.
Example: Mr. Critelli, an Orlando apartment owner, wants to relocate to Cleveland to be near his family and simplify his real estate management. Through a 1031 exchange facilitated by Madison & Hoyt, he sold his Orlando apartments and reinvested the full equity into a NNN industrial property in Cleveland with a national tenant, deferring all capital gains taxes.
1031 Exchange Advantage: An Illustration
Investor Peter sells a shopping center (original cost: $500,000; current value: $1,000,000) and wants to defer capital gains taxes via a 1031 exchange, as advised by his Madison & Hoyt broker. He identifies a $2,000,000 replacement property. Over 10 years, $200,000 in depreciation and $25,000 in capital improvements were taken. Selling costs are estimated at $150,000.
Step One-Determine the Cost Basis
| Description | 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
| Description | Typical Sale | 1031 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
| Description | Typical Sale | 1031 Sale |
|---|---|---|
| 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
| Description | Typical Sale | 1031 Sale |
|---|---|---|
| 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)
1031 Exchange Impact: Cash vs. Leverage
A typical sale yields $372,650 cash after $127,350 in taxes. However, a 1031 exchange allows these deferred taxes ($127,350) to increase the replacement property investment by $509,400.
Key Disadvantage: The replacement property's basis is reduced by the deferred gain from the sold property.
Steps of a 1031 Exchange
Step One: Pre-Sale Consultation
Contact Madison & Hoyt for expert advice on whether a 1031 Tax Exchange aligns with your financial goals. We'll gladly coordinate a consultation with your financial or legal advisors. Upon determining the benefits of a 1031 exchange, Madison & Hoyt will list your property for sale and simultaneously begin searching for suitable replacement properties based on your criteria. We will also provide a list of reputable Qualified Intermediaries to ensure full compliance with all 1031 exchange regulations.
Step Two: Sale of Relinquished Property
Thanks to Madison & Hoyt's effective marketing, a buyer is secured. The sale proceeds will be directly wired to your chosen Qualified Intermediary and held securely in an escrow account. The day following the closing of your relinquished property marks the beginning of the 45-day identification period (Day One).
Step Three: Identification of Replacement Property
Within the critical 45-day timeframe, Madison & Hoyt will expedite the necessary research and due diligence to identify suitable replacement properties. The most commonly utilized identification rule is:
- The Three Property Rule: You may identify up to three properties, regardless of their individual values.
Step Four: Purchase of Replacement Property
Once a replacement property (or properties) has been identified, you must complete the purchase within 180 days following the sale of your relinquished property.
Basic Rules of a 1031 Exchange
01
Investment Intent
Both the sold property (Relinquished Property) and the purchased property (Replacement Property) must be held for investment or business use. Personal residences, vacation homes, and dealer properties are not eligible.
02
Time Frames
- Identification: Replacement Property must be identified within 45 calendar days of selling the Relinquished Property.
- Purchase: Replacement Property must be purchased within 180 calendar days of selling the Relinquished Property, or by the due date of your tax return for the year of the sale.
- Important: These deadlines are strict and cannot be extended. You don't need a contract to identify properties.
03
Like-Kind Property
The Replacement Property must be "like-kind" to the Relinquished Property. Most real property held for investment or business use qualifies as like-kind to other such real property (e.g., office building for a shopping center or vacant land). Personal-use and dealer properties do not qualify.
04
Common Ownership
The seller of the Relinquished Property must be the same entity purchasing the Replacement Property. A Qualified Intermediary (QI) acts as your agent to legally sell the relinquished property and buy the replacement property on your behalf. Sale proceeds go directly to the QI; you cannot directly receive the funds.
- Partnerships: Changing partnership interests by over 50% between properties can disqualify the exchange. A common strategy involves dissolving the partnership into a "tenants-in-common" (TIC) ownership, where each owner's interest is treated as separate property for exchange purposes.
05
Property Value
The Replacement Property's value must be equal to or greater than the Relinquished Property's value. Otherwise, the difference may be subject to tax.
06
Exchange Funds
All cash proceeds from the sale of the Relinquished Property must be used to purchase the Replacement Property. Receiving cash, notes, or personal property ("boot") is taxable. Seller financing on the Relinquished Property may also trigger tax as principal is repaid.
Avoiding "Boot" and Types of Exchanges
Avoiding "Boot"
To completely avoid "boot" (taxable proceeds), the replacement property's sales price, equity, and mortgage amount must be equal to or greater than those of the relinquished property.
Types of Exchanges
01
Forward Delayed Exchanges
This common exchange type involves selling the relinquished property and purchasing the replacement property within 180 days. For IRS safe harbor, a Qualified Intermediary (QI) must hold the sale proceeds during this period.
Common Misconceptions About 1031 Exchanges
Simultaneous Exchange Not Required
A direct, simultaneous property swap is not necessary. Forward Delayed Exchanges allow a 180-day window for replacement property purchase after the relinquished property sale. Reverse Exchanges involve purchasing the replacement property before selling the relinquished one.
"Like-Kind" is Broad
"Like-kind" under Section 1031 refers to the nature of the property (real estate for real estate), not its specific type. A shopping center can be exchanged for raw land, or an office building for an investment residence.
Not a Tax Loophole
Section 1031 has been a part of the tax code since the 1920s. It's a legitimate tax deferral strategy that encourages investment.
Qualified Intermediary is Essential
You cannot directly hold sale proceeds and perform a valid 1031 exchange. A Qualified Intermediary (QI), who must be independent and not your agent in the past two years, provides safe harbor protection. Exchanges without a QI are at high risk of IRS invalidation.
Strict Deadlines
The 45-day identification and 180-day purchase deadlines have no extensions except for federally declared disasters.
Tax Deferral, Not Elimination
A 1031 exchange defers capital gains taxes; it doesn't eliminate them. The cost basis carries over to the replacement property. Strategic, ongoing 1031 planning can potentially lead to tax savings over time.
Disclaimer: This information is for informational purposes only and does not constitute legal or tax advice. Consult with your attorney or CPA for advice specific to your situation.