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Lets talk about a 1031 exchange, its a tool that commercial real estate investors have at their fingertips when they are disposing of properties and acquiring another with the proceeds.
Now with that said I think that we need to understand the dynamics of a 1031 exchange at bit first because a properly structured and executed 1031 exchange allows for a commercial real estate investor to dispose of a property without being subjected to the good ole capital gains tax and then they can subsequently use those full funds to purchase a new “Like-Kind” property.
Now before we move further let me expand on the term “Like-Kind” as its pretty general and doesn’t mean what you may think it does. Most that are not familiar with a 1031 would automatically think that if they dispose of an office building that they would have to buy an identical office building of equal value and that is not the case. You can exchange an office building for an apartment building, shopping center or even raw land for development. So as you can see the Internal Revenue Code rule is pretty flexible.
Now here is what is stated in the Internal Revenue Code Section 1031 (a)(1) :
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Now let me expand a little further into that with an example,
A commercial real estate investor has a $500,000 capital gain and incurs a tax liability of approximately $175,000 in combined taxes (which include federal and state capital gains taxes and depreciation recapture if any) when the property is disposed of. Only $325,000 is what is left over to reinvest in another property without the use of new money.
Now lets assume that the investor needs a 25% down payment with a 75% loan-to-value ratio, the investor would only be able to purchase a property valued at approximately $1,300,000 , that if they do not intend on adding new money to the investment.
Now here is where it gets pretty interesting, so if the same investor made the decision to do a 1031 exchange then the investor would be able to reinvest the entire amount of $500,000 and then purchase a property worth in the range of $2,000,000 , again assuming they do not invest new money into the deal, and also with this we are still using the 25/75% ratio. (of course the dollar amounts can vary from $100,000 and up, I just used those numbers as an example)
As I mentioned earlier this is a prime example of the benefits and actual protection that a 1031 exchange affords to a commercial real estate investor. The main protection is that from the capital gains tax and this protection allows the investor to realize an increased return on their investment and their portfolio growth.
I just have to stress that any investor looking to take advantage of a 1031 exchange should consult and/or retain an experience commercial real estate attorney. It may cost you a little more now but trust me it will be an asset to you later on should an issue arise.
One other thing to understand about a 1031 exchange is that you may even be able to exchange one business for another, that is a different animal all together however it is possible but retain that commercial real estate attorney if you are exploring this option. Also 1031 exchanges are not for personal use they are only for investment and business properties.
I’ll be writing more commercial real estate articles and will touch more on 1031 exchanges.
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TEN THINGS TO KNOW
Here are ten things that you should know about 1031 Exchanges:
A 1031 isn’t for personal use.
The provision is only for investment and business property, so you can’t swap your primary residence for another home. There are ways you can use a 1031 for swapping vacation homes, but this loophole is much narrower than it used to be. For more details, see No. 10.
But some personal property qualifies.
Most 1031 exchanges are of real estate. However, some exchanges of personal property (say a painting) can qualify. Note, however, that exchanges of corporate stock or partnership interests don’t qualify. On the other hand, interests as a tenant in common (sometimes called TICs) in real estate do.
“Like-kind” is broad.
Most exchanges must merely be of “like-kind”–an enigmatic phrase that doesn’t mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But again, there are traps for the unwary.
You can do a “delayed” exchange.
Classically, an exchange involves a simple swap of one property for another between two people. But the odds of finding someone with the exact property you want who wants the exact property you have are slim. For that reason the vast majority of exchanges are delayed, three party, or “Starker’ exchanges (named for the first tax case that allowed them). In a delayed exchange, you need a middleman who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you. This three party exchange is treated as a swap.
You must designate replacement property.
There are two key timing rules you must observe in a delayed exchange. The first relates to the designation of replacement property. Once the sale of your property occurs, the intermediary will receive the cash. You can’t receive the cash or it will spoil the 1031 treatment. Also, within 45 days of the sale of your property you must designate replacement property in writing to the intermediary, specifying the property you want to acquire.
You can designate multiple replacement properties.
There’s long been debate about how many properties you can designate and what conditions you can impose. The IRS says you can designate three properties as the designated replacement property so long as you eventually close on one of them. Alternatively, you can designate more properties if you come within certain valuation tests. For example, you can designate an unlimited number of potential replacement properties as long as the fair market value of the replacement properties does not exceed 200% of the aggregate fair market value of all the exchanged properties.
You must close within six months.
The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old. Note that the two time periods run concurrently. That means you start counting when the sale of your property closes. If you designate replacement property exactly 45 days later, you’ll have 135 days left to close on the replacement property.
If you receive cash, it’s taxed.
You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash, known as “boot”, will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.
9.You must consider mortgages and other debt.
One of the main ways people get into trouble with these transactions is failing to consider loans. You must consider mortgage loans or other debt on the property you relinquish, and any debt on the replacement property. If you don’t receive cash back but your liability goes down, that too will be treated as income to you just like cash. Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property you receive in exchange is only $900,000. You have $100,000 of gain that is also classified as “boot,” and it will be taxed.
Using 1031 for a vacation house is tricky.
You can sell your primary residence and, combined with your spouse, shield $500,000 in capital gain, so long as you’ve lived there for two years out of the past five. But this break isn’t available for your second or vacation home. You might have heard tales of taxpayers who used a 1031 to swap one vacation home for another, perhaps even for a house where they want to retire. The 1031 delayed any recognition of gain. Later they moved into the new property, made it their primary residence and eventually planned to use the $500,000 capital gain exclusion.
In 2004 Congress tightened that loophole. Yes, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. Example: You stop using your beach house, rent it out for six months or a year and then exchange it for other real estate. If you actually get a tenant and conduct yourself in a businesslike way, you’ve probably converted the house to investment property, which should make your 1031 exchange OK. But if you merely hold it out for rent but never actually have tenants, it’s probably not. The facts will be key, as will the timing. The more time that elapses after you convert the property’s use the better. Although there is no absolute standard, anything less than six months of bona fide rental use is probably not enough. A year would be better.
If you want to use the property you swapped for as your new second or even primary home, you can’t move in right away. In 2008 the IRS set forth a safe harbor rule under which it said it would not challenge whether a replacement dwelling qualified as investment property for purposes of a 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange: (1) you must rent the dwelling unit to another person for a fair rental for 14 days or more; and (2) your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
Moreover, after successfully swapping one vacation/investment property for another, you can’t immediately convert it to your primary home and take advantage of the $500,000 exclusion. Before the law was changed in 2004 an investor might transfer one rental property in a 1031 exchange for another rental property, rent out the new rental property for a period of time, move into the property for a few years and then sell it, taking advantage of exclusion of gain from the sale of a principal residence. Now, if you acquire property in the 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date the property was acquired in the 1031 like-kind exchange. In other words, you’ll have to wait a lot longer to use the primary residence capital gains tax break.
Real Estate investors, both buyers and sellers can contact FGA to find out how we can be an asset to you, for those looking to complete the buy side of a 1031 exchange we can assist them in targeting the right property that fits their needs as well as completes the exchange, we can assist sellers by introducing your properties to buyers seeking to complete their exchange.
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