Possible Scenarios for 1031 Exchange.
Let’s say you bought a residential property in the San Francisco Bay Area for $250K twenty years ago. Since this property is located in a good area, the value has reached $1 million. Over the years, you refinanced the original loan to consolidate your other debts and currently have a $300K mortgage on the property. Each month, you collect $3,000 from rent. After paying $1,800/month for loans, $400/month for property taxes and $60/month for insurance, you get $500 cash flow/month after paying property management and maintenance fees.
As you get older, you realize that you need a reliable second source of income so that you are not completely dependent on your salary. You’re also not happy with only $500 cash flow a month on $750K equity in your rental investment. So, when you look at an attractive multi-tenant shopping mall in a mid-range Dallas suburb, a 100% NNN lease with a Net Operating Income of $195K/year (income after all expenses except mortgage payments) is on the market for $2.6 million, offering 7 ,5% cap, you’re excited!
Since the residential real estate market in the Bay Area is so lucrative for sellers, you are considering selling your rental property to purchase this shopping strip. You estimate that you will have to pay approximately $250K in federal and state income taxes on $800K in capital gains ($1M minus $250K purchase price and selling costs, plus $50K in depreciation back). You just hate having to pay $250K to the government – money that might be used for your down payment at the grocery store. There is a better way – a way to defer income taxes.
What is a 1031 Tax Deferred Exchange?
Section 1031 of the Internal Revenue Code generally provides that neither gain nor loss is recognized when qualifying property is exchanged for another similar qualifying property. In the scenario above, you could defer paying $250K in both federal and state taxes if you acquired another investment property with equal or greater debt and equal or greater equity. In other words, if you buy another real investment property for $1 million or more, using all of the net proceeds as a down payment, then you can defer taxes by $250 thousand. Basically, the government will lend you $250K, no interest. And you can repeat this hold and never pay income tax.
How Do You Qualify for 1031 Exchange?
You have to adhere to some strict rules. Failure to comply with any of the rules will disqualify your transaction from the 1031 tax-deferred exchange.
- You have to trade. The property you buy (replacement property) must have the same or greater debt AND equal or greater equity than the property you sell (release property). This means you have to put all the net results of the released properties into the replacement properties. The fair market value (FMV) of the replacement property must also be more than the FMV of the disposed property.
- Eligible properties must be similar. Property that is disposed of and replaced must be held for productive use in trade or business or for investment, before and after the exchange. And one type of property cannot be exchanged for a property of a different type. For example, you may not exchange a residential rental property for the property you wish to occupy as your primary residence – not an eligible property. And you shouldn’t trade factories for equipment – unlike goods. On the other hand, residential and commercial real estate are of the same type. So you can swap residential rental properties for shopping malls.
- In a pending exchange, you must identify the replacement property within 45 days and receive it within 180 days of the closing date of the relinquished property or the due date of your tax return (with extension) whichever is sooner.
- You can identify up to 3 replacement properties and must close escrow with at least 1 of 3. Alternatively, you can identify as many properties as you want as long as the total value of these properties does not exceed 200% of the value of the property left behind.
- You should acquire property for investment purposes and not for resale for profit. While the IRS is silent about how long you hold property before you can qualify for a 1031 exchange. Most tax advisors believe that two years is an adequate holding period for investment purposes. You should check with your tax accountant if the investment period is shorter to make sure your 1031 can survive an IRS audit.
- You must have an intermediary in place that holds the proceeds from the sale of the foreclosed property. Most investors use an exchange company as a qualified intermediary for a pending 1031 exchange.
- If you exchange property with related persons (your children, parents), then neither party may dispose of the property within 2 years.
- If the proceeds of the sale are held in an interest-bearing account during the exchange, you must receive the interest AFTER closing the escrow of the replacement property.
What Expenses Are Allowed?
You can use the 1031 proceeds to pay certain selling costs of the foregoing property and purchase costs for replacement properties: owner rights insurance premiums, escrow agent or closing attorney fees, real estate brokerage commissions, 1031 brokerage fees, document transfer taxes, listing fees, and tax advisory fees. You cannot use 1031 to pay for these costs: loan fees/points, appraisal fees, mortgage insurance premiums, lender ownership insurance policy premiums, property insurance premiums, repair and/or maintenance costs.
Strategies for Success 1031 Exchange
The following strategy is intended for investors who are looking for commercial property as a replacement property.
- Have 3 plans for your 1031 exchange: A, B, and C with plan A being the best case and plan C being the worst case. Have at least one different property for each plan.
- Start looking for replacement properties early. Since you only have 45 days to identify a replacement property, you must submit a bid as soon as the released property is in escrow. By the time you close escrow on a relinquished property, you must have one offer accepted for the replacement property. This first property need not be the most desirable property at the best price. Mentally, you should think of it as a plan-C property for the worst-case scenario. That way, you don’t have to wait until the last minute to make an offer. It is also meant to relieve your worries so you sleep well, such as “Oh my God, what if I can’t find a replacement property?”.
- Identify more than 1 replacement property. If something unexpected comes up with your first choice, for example contaminated soil, you have a plan B and plan-C property to fall back on.
- Specify a 30 day due diligence and cancellation period in the contract. This will give you more time to define more than 1 property.
- Think twice about choosing a replacement property assuming a loan. It is much more difficult to get a lender’s approval for an assumed loan than it is for a new loan. In addition, you only have one chance to get loan assumption approval versus multiple chances to get new loan approval. You don’t want your loan assumption to be rejected by a lender after a 45 day identification period.
Question for Exchange Intermediary 1031
Technically, you don’t need a 1031 exchange company to handle the exchange. However, it is advisable to have an expert assist you. This company will ensure that you comply with the strict IRS rules. To decide which company to help you, you should consider:
- It costs around $500-$750 per transaction. Companies that charge less are likely to limit you to 3 replacement properties and companies that charge more may not have that limit.
- Whether your proceeds will be held in a separate trust account where your money is insured by the FDIC or combined with the main company account. If the company is experiencing where some of them did during the recession, it’s easier to show the money in a separate trust account is your money and not the exchange company’s money.
- Whether your proceeds will earn interest and the money is insured.
What if you want to buy a replacement property first?
For some investors, the strict 45 day identification period and 180 day exchange period may be too short. Also, some investors will only consider doing a 1031 exchange only if they want to find a suitable replacement property. An alternative is to consider a reverse swap where the replacement property is purchased first before the relinquished property is sold. However, the substitute goods must be owned by the intermediary during the suspension of the exchange of similar goods until the taxpayer can sell the goods that have been released. Then the replacement property is exchanged to the taxpayer. Delayed reverse exchange is an advanced strategy with a different set of challenging problems that is not meant for the average investor. You should consult a tax advisor to guide you.
What are the potential problems?
Due to the time limit in exchange 1031, it is possible that some people may want to take advantage of your situation. So you have to be mentally aware of and accept the fact that as a 1031 buyer, you may not be in the best position to negotiate.
- There are sellers or listing brokers who feel very positive about 1031 buyers. They reasoned this buyer had to buy and close escrow or had to send a large check to Uncle Sam. On the other hand, some sellers or listing brokers feel negatively about 1031 buyers. They reasoned 1031 buyers would offer to buy 3 properties and close escrow with one. So, there is a 33% chance 1031 buyers will close the escrow. So for this seller may not accept your offer.
- Seller knows 1031 buyer must close escrow. So they may become less flexible in negotiations with 1,031 buyers after the purchase contract is executed. For example, you ask for a repair credit which they may approve in a normal transaction but may decline in a 1031 transaction. So, it’s important to have backup properties, just in case.
- Some lenders may reduce the loan amount and/or require 1031 buyers to put all proceeds from the sale into replacement properties.
Successful Exchange
Your offer of $2.6 million for the shopping center is accepted. The bank lends you $1.82 million (70% LTV) at 4.5% interest amortized over 25 years. After paying $10,116/month for the mortgage, you still have over $6,000 positive cash flow per month! This is a substantial increase from $500 per month before 1031 exchange.