Why Do a 1031 Exchange Instead Of Just Selling My Investment Property?
Of Course, you don't have to, But consider this:
Why exchange real property?
To save taxes, yes, but said more succinctly, to build
your estate with pre-tax dollars. Using proper
exchange techniques will result in what is effectively interest free money
from the government. Taxes
you owe can be paid later (or deferred indefinitely), allowing you the
use of that money today to buy more, or more expensive, investment property.
Other reasons to Exchange include:
Increasing depreciable basis by acquiring property encumbered with a
larger debt.
Acquiring sheltered income by exchanging your unimproved land for
improved property.
Acquiring property without cash, when sales may be impossible.
Consolidating assets by exchanging many properties for one larger
property.
Receiving nontaxable cash by exchanging and refinancing after and
independent of the exchange.
Diversifying holdings without tax consequence.
Here's an example of how not paying the taxes will allow you to build your estate faster:
If you acquired an investment property for $50,000 and sold it
for $150,000 you would have a $100,000 capital gain (that is not including the
gain you would realize because of depreciation taken during the
holding period of the property, which lowers the basis and results in higher
realized gain). After taxes (30% for the purpose of example, state and federal),
you would end up with $70,000 to do what you like
with, but let's assume you will use it as a down payment on another investment
property.
Sale price:
$150,000
(Minus) Original Cost $ 50,000
(Equals) Capital Gain $100,000
(Times) Tax Bracket 28% (Fed 20% +
State 8%) Your state may differ.
(Equals) Taxes due: $ 28,000
Remaining Balance available for another investment =
$72,000
Taking that $72,000 and leveraging it 4 to 1 would result in a
purchase of a $288,000 property.
If you received a 6% annual appreciation in year one it would result in an
equity increase of $17,280.
If you structured the sale in accordance with section 1031, and did not
have to pay the taxes
at the time of the disposition (selling) of the first property (exchanging it
instead of selling it),
you could invest the entire $100,000 gain.
Leveraged at the same 4 to 1 ration would allow you to purchase a $400,000
property. At the
same 6% rate of appreciation, your increase in equity in year one would
result in a $24,000 increase. Multiply this added
$6,720 equity buildup over a 20 year investment horizon and the result is
substantial. This is a 38.8% increase in your equity in the first year of
ownership.
Internal Revenue Code Section 1031 says no gain or loss shall be recognized
(taxed) if property held for investment is exchanged solely for a property of
"like kind" to be held either for :
1. Production of income, or
2. Investment, or
3. Productive use in trade or business
Property must be of "like kind." This means real property for real
property, personal property for personal property. "Like kind" is broadly
defined, that is, all real estate qualifies regardless of the "grade or
quality." It is the "nature or character" of the property (real or personal) and
not the name of the improvements (office building, apartment, hotel, etc) that
determines "like kind". This was emphasized in Commissioner of Internal Revenue
v. Chrichton. This case involved the exchange of mineral interests and
improved real property. The mineral interests were held to be like kind
property because under state law they were considered real property. In a
subsequent revenue ruling, the IRS indicated that water rights also met
the like kind test.
Property not qualifying:
1. Stock in trade
2. Partnership interests
3. Stocks, bonds, notes
4. Dealer property
Multiple Properties:
Nothing in Section 1031 prevents a taxpayer from exchanging out of or into
multiple properties.
Tax Consequences:
Exchanges can be fully deferred or partially deferred. Any unlike kind property
received in the exchange is considered boot and is recognized (taxable) in the
year of the exchange.
Boot is:
1. Cash or the equivalent of cash
2. Any unlike kind property
3. Mortgage relief
4. Any combination of the above
Cash paid offsets mortgage relief boot. The lower of the gain or the boot
is taxable in the year of the exchange.
For a completely tax deferred exchange you must trade up in equity, value,
and loan.
Basis of Property Received:
This is referred to as substitute basis and is the Fair Market Value of the
property received minus the deferred gain (or plus any deferred loss).
The Exchange Process:
As it is in any real estate transaction, you must first identify the objectives
of the property owner. What do they want to accomplish? Management problems,
lack of control, cash flow, tax concerns; sometimes the owner is not sure of all
the circumstances and it may take some time and counseling to make the
determination. A basic requirement is that all participants receive the same
value that they give. The end result should be that there are as many winners as
there are participants. Determination of value to the participants in a real
estate exchange is not complete without considering the improvement the
transaction will make in the owner's life. The analysis must take into
consideration the personal circumstances of the participants lives.
Two Party Exchange:
As mentioned before, to structure a completely tax deferred exchange, the
investor must acquire property (properties) with equal or greater equity and a
larger fair market value than the property transferred (up
in equity and value). This assumes that there is gain realized and that the
taxpayer pays boot and assumes a larger loan.
The very common three party exchange is comprised of a sale and an
exchange, or an exchange and a sale.
You must remember there are specific "Rules" set down by the IRS that
must be followed to make your exchange tax deferred. Contact your 1031 Exchange
Broker Specialist BEFORE closing a "sale escrow" to see if you can
qualify your sale for an exchange and thus defer the capital gains taxes.
I hope you find this useful.
Contact Jim Smith #350, Broker
Specializing in 1031 Exchanges since 1972
Thanks to Saul Klein for parts of this article.
Be sure to contact your tax advisor, legal advisor, Qualified Intermediary, or qualified Real Estate Investment Broker to assist you in your planning to create a successful qualified 1031 simultaneous or delayed exchange.
Good luck and happy tax planning.
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