A Possible Scenario for 1031 Exchange.
Suppose you bought a residential property in the San Francisco Bay Area for $250K twenty years ago. Since the property is located in a good area, its value has appreciated to $1M. 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 of rent. After paying $1,800/month for the loan, $400/month for property taxes, and $60/month for insurance, you get $500 cash flow after paying property management and maintenance expenses.
As you grow older, you realize that you need a second source of reliable income so you are not entirely dependent on your salary. You are also unhappy with just $500 of cash flow a month on your rental investment’s $750K of equity. So when you see an attractive multi-tenant shopping strip in a middle-class Dallas suburb, 100% NNN lease with $195K/year of Net Operating Income (income after all expenses except the mortgage payment) on the market for $2.6M offering a 7.5% cap, you get excited!
Since the residential real estate market in the Bay Area has been very favorable to sellers, you consider selling your rental property to buy this shopping strip. You estimate that you would have to pay about $250K in federal and state income taxes on $800K of capital gain ($1M less $250K purchase price and selling fees, plus $50K in depreciation recapture). You hate paying $250K to the government – money that may go toward your down payment on the shopping strip. There is a better way – a way to defer the income tax.
What is a 1031 Tax-Deferred Exchange?
Section 1031 of the Internal Revenue Code generally provides that neither gain nor loss is recognized if the qualifying property is exchanged for other qualifying property of a like-kind. In the above scenario, you may defer the payment of $250K in federal and state taxes if you acquire another investment property with equal or more outstanding debt and equal or more significant equity. In other words, if you buy another real investment property for $1M or more, using all of the net proceeds as a down payment, you may defer the $250K of taxes. Essentially, the government would lend $250K to you without interest. And you may repeat this deferral and never pay income taxes.
How Do You Qualify for a 1031 Exchange?
You must comply with several strict rules. Failure to satisfy regulations will disqualify your transaction from a 1031 tax-deferred exchange.
- You must trade up. The property you buy (replacement property) must have an equal or more outstanding debt AND equal or more significant equity than the property you sell (relinquished property). You must put all the net proceeds from the lost property into the replacement property. The fair market value (FMV) of the replacement property must also be more than the FMV of the abandoned property.
- The qualifying property must be of a like-kind. The relinquished and replacement properties must be held for productive use in a trade, business, or investment before and after the exchange. And one kind of property may not be exchanged for property of a different kind. For instance, you may not exchange a residential rental property for one you intend to occupy as your principal residence – not a qualifying property. And you may not exchange a factory for equipment – not like kind. On the other hand, residential and commercial fundamental properties are similar. So, you may exchange a residential rental property for a shopping center.
- In a delayed exchange, you must identify the replacement property within 45 days and receive it within 180 days from the closing date of the relinquished property or by the due date of your tax return (with extension), whichever is sooner.
- You may identify up to 3 replacement properties and must close escrow with at least 1 of the 3. Alternatively, you may remember as many properties as you want as long as the total value of these properties does not exceed 200% of the value of the relinquished property.
- You must acquire the property for investment purposes and not primarily to resell for profit. While the IRS is silent about how long you have to hold the property before you can qualify for a 1031 exchange. Most tax advisors believe two years is an adequate holding period for investment purposes. You should check with your tax accountant if the investment period is shorter to ensure your 1031 can withstand an IRS audit.
- You should have an exchange intermediary holding the sales proceeds of the relinquished property. Most investors use an exchange company as the qualified intermediary for a delayed 1031 exchange.
- If you exchange property with a related person (your children, parents), both parties may not dispose of the properties within two years.
- If the sale proceeds are deposited in an interest-bearing account during the exchange, you must receive the goods AFTER the close of escrow of the replacement property.
What Expenses are Permissible?
You can use 1031 proceeds to pay for specific selling expenses of the relinquished property and buying expenses for the replacement property: owner’s title insurance premiums, escrow agent or closing attorney’s fees, real estate broker’s commissions, 1031 exchange intermediary’s fees, document transfer taxes, record fees, and tax advisor fees. You cannot use 1031 to pay for these expenses: loan fees/points, appraisal fees, mortgage insurance premiums, lender’s title insurance policy premiums, property insurance premiums, repairs, and maintenance costs.
Strategies for a Successful 1031 Exchange
The following strategies are intended for investors looking for commercial property as replacement property.
- Have three 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 project.
- Start looking for a replacement property early. Since you have only 45 days to identify replacement properties, you should make an offer as soon as the relinquished property is in escrow. By closing escrow on the abandoned property, you should have one bid accepted on a replacement property. This first property does not need to be the most desirable at the best price. Mentally, it would help if you considered it a plan-C property for the worst-case scenario. That way, you don’t wait till the last minute to make an offer. It is also intended to take away your worries so you sleep well, such as “Oh my God, what if I cannot find a replacement property?”.
- Identify more than one replacement property. If something unexpected comes up with your first choice, e.g., the soil is contaminated, you have a plan B and plan-C properties to fall back on.
- Specify a 30-day due diligence and cancellation period in the contract. This will give you more time to specify more than one property.
- Think twice about choosing a replacement property with a loan assumption. It’s much harder to get lender approval for a loan assumption than for a new loan. Moreover, you have only one chance to get support for loan assumption versus many opportunities to get a new loan approved. You don’t want your loan assumption denied by the lender after the 45-day identification period.
Questions for a 1031 Exchange Intermediary
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 strict IRS rules. To decide which company to help you, you should consider:
- The fee is around $500-$750 per transaction. The company that charges less tends to limit you to 3 replacement properties, and the company that charges more may not have that limit.
- Whether your proceeds will be deposited in a separate trust account where your money is FDIC insured or blended with the company’s leading performance. If the company goes under, which some of them did during the recession, it’s easier to show the money in the separate trust account is your money and not the exchange company’s money.
- Whether your proceeds will earn any interest and the money is insured.
What if you want to buy the replacement property first?
For some investors, the strict 45-day identification and 180-day exchange period may be too short. In addition, some investors would only consider doing a 1031 exchange only if they are to find suitable replacement properties. The alternative is to consider a reverse exchange in which the replacement property is purchased before the relinquished property is sold. However, the replacement property must be owned by an intermediary party during the pendency of the like-kind exchange until the taxpayer can sell her relinquished property. Then the replacement property is exchanged to the taxpayer. A reverse delayed exchange is an advanced strategy with a different set of challenging issues not meant for average investors. You should consult a tax advisor to guide you.
What are some of the potential issues?
Due to the time limits in the 1031 exchange, some people may want to take advantage of your situation. And so, you should realize and accept that as a 1031 buyer, you may not be in the best position to negotiate.
- Some sellers or listing brokers feel very positive about 1031 buyers. These buyers will have to buy and close escrow or send a big check to Uncle Sam. On the other hand, some sellers or listing brokers feel negative about 1031 buyers. The reason 1031 buyers will offer to buy three properties and close escrow with one. And so, there is a 33% chance the 1031 buyers will close escrow. And so these sellers may not be receptive to your offers.
- Sellers know that 1031 buyers have to close escrow. And so they may become less flexible in negotiation with 1031 buyers once the purchase contract is executed. For example, you ask for repairs credit which they may agree to in a typical transaction but may say no in 1031 transactions. And so, it’s crucial to have backup properties, just in case.
- Some lenders may reduce the loan amount and require the 1031 buyers to put all the sale proceeds into the replacement property.
A Successful Exchange
Your offer of $2.6M for the shopping center is accepted. The bank lends you $1.82M (70% LTV) at 4.5% interest amortized over 25 years. After paying $10,116/month for the mortgage, you still have a positive cash flow of over $6,000 a month! This is a substantial increase from $500 per month before the 1031 exchange.