The 1031 Tax Deferred Exchange

I thought I’d take the time to talk about one of the most powerful tools out there. This discussion deals with the tax deferral of gain realized on investment property. I’m sure that you’re already aware of the fact that home owners are protected on a very large portion of their gain when they sell their primary residences. If you’ve owned and lived in your home for two of the last five years you are exempt for paying taxes on your capital gain. There are limits on the amount of gain that is exempted. It is up to $250,000 for a single person and $500,000 for a married couple. That’s a lot of tax free gain.

When it comes to investment property we are looking at something else entirely. You cannot simply buy, hold and sell an investment property without facing a tax on the gain. One way to protect yourself is to participate in an IRC 1031 Tax Deferred Exchange.

Let’s look at the structure of the exchange. You’re an investor that purchased a property years ago for the remarkably low price of $100,000.00. Many years later you’ve decided that you no longer want to hold this property and you put it on the market. You and your real estate professional have priced the property well and it sells for $300,000.00. Prior to this, of course, you spoke with your CPA who told you what would happen to the profit or gain you’re realizing from the sale. Essentially, you are looking paying federal tax, up to 15%, state tax in Oregon of 9% and a percentage of the depreciated value of the property, approximately 25% of that value. Your gain is based on the difference between the basis and the net sales price. Calculating the basis is somewhat complicated but for this example we’ll figure the purchase price plus any capital improvements and the cost of sale (commissions, repairs, etc). Bear in mind that this is a simplified version for determining the gain but it is still adequate for our purpose. Your CPA should be your only consultant when it comes to generating these figures. For argument’s sake we’ve determined that your actual gain is $150,000.00. You’re looking at a potential tax liability of $36,000.00 not counting the additional obligation for the depreciated value. Your profit has just been reduced to $114,000.00. That’s a big adjustment.

However, if you’d participated in the 1031 Exchange all of the tax on that gain could have been deferred. The process to enter into the exchange should start when the property is listed for sale. Your realtor will list the property indicating that the seller, you, intends to participate in an IRC 1031 Tax Deferred Exchange. There is specific language in the sale agreement, (Section 29), that informs the purchaser that the seller may elect to complete said exchange. There is no impact on the purchaser, financial or otherwise, unless the entire sale is written subject to that exchange. Section 29, followed up with an addendum indicating that this will be part of an exchange, serves as further notice of intent.

With all parties in agreement we proceed to the next step. The seller employs the services of an exchange company. The exchange company acts as a facilitator for the sale. It holds funds and processes paperwork that establishes the legitimacy of the exchange. In the old days the property title was transferred from the seller to the exchange company for a fraction of a second then transferred to the purchaser. Now there is a direct deed of the property from the seller to the purchaser. From the IRS perspective, however, the facilitator is considered to be the seller.

As with any construct there are many rules to follow. There are timelines to meet and documents to be executed. The minute the transaction is complete, that is, the day of recording, the process is set in motion. The $150,000.00 is held in an account. The seller is now in the position of fulfilling the requirements of the exchange. He or she has to purchase another like-kind property. The seller has 45 days to identify the property or properties and 180 days to close or finalize the sale(s). There is no latitude here. The periods are definite and unalterable. In addition, the sales have to be structured so that the seller is still carrying the same amount of debt that was attached to the previously sold property. There is another important stipulation. Any money that is not used in the deferral is considered boot and subject to tax. If you keep a dollar you pay the 24% and the portion of the depreciated value as well. You can’t touch any of it. I received a newsletter from First American Exchange the other day that indicated that there might be some flexibility regarding boot but, upon speaking with a representative from the company, said flexibility is very case specific and not a guarantee. Let’s stick with the assumption that boot is boot and is, therefore, subject to taxation.

While the timelines are very rigid the definition of like-kind is very broad. You can sell a single family rental and move that gain into a 40 unit apartment. It can go the other way as well. Again, before engaging in the transfer/exchange of any property, get a handle on the rules. Find out if your property is eligible for an exchange. For example, there is a holding period requirement for the relinquished property. If held for less than two years the IRs may decide that the property was held for sale rather than investment. Properties held for sale do not qualify.

The last piece that I find interesting is that the gain, here the $150,000.00, is held in an interest bearing account. I was involved in an exchange that was completed just shy of the 180 days and my profit was sitting in an account earning 5% interest. In our example here the interest earned in 180 days is right around $3750.00. So, in addition to deferring the tax on your gain you are accruing interest as well. It’s a beautiful thing!!

Lastly, don’t forget that any financial move has to be structured correctly. Advice and guidance for the proper professionals are a must. Also, bear in mind that the tax here is deferred, not forgiven. The same issues are present when you sell the new property as well.

As always, these postings are meant to pique your interest. For more detailed information on 1031 Exchanges you can contact my exchange company at www.firstexchange.com. They’re a great resource and always available for you. You can reach me as well at gary@vppihomes.com or through the website at www.vppihomes.com.

Thanks again for reading the blog. Your comments and feedback are always welcome. Until next time, the information has been… On the House.