Many real estate investors talk about 1031 exchanges. What is a 1031 exchange? In simple terms, it is a method of selling a property and buying other property without triggering capital gains tax. In the event you have owned a property for a long period of time and you are thinking about selling, you might want to explore this method of selling.
If you read my post on Return on Investment, you might recall my discussion about depreciation and recapture as well as capital gains tax on the sale of a property and how to calculate your net return on your investment. If you have not read it, you can review it here.
A 1031 exchange allows you to sell a property and buy another property similar to the one you are selling without having to pay the recapture tax and the capital gains tax. I am not suggesting that you will never have to pay tax. Essentially, you are deferring the tax to some future date.
How Exactly Does a 1031 Exchange Work?
The best way to illustrate how a 1031 exchange works is with a case study. Let’s use the same case study that I used in the Return on Investment post. This is a straight forward sale.
Based on these assumptions, the tax owed on the sale of this property is:
Utilizing a 1031 exchange, the tax payable of this sale is deferred. However, this method can only be used if the seller is planning on purchasing another property with the net proceeds of the sale of the property in this example.
What Are The Rules?
1. The exchange must be between similar types of property. The IRS defines this as a “like-kind” exchange. For example, you cannot exchange property for factory equipment. They are two different types of assets. However, you can exchange a house for an apartment building or an apartment building for a shopping center. The only restriction is that the exchange has to occur with properties located inside the USA. International exchanges are not permitted.
2. The exchange only applies to commercial or investment property. You cannot use a 1031 exchange for your personal residence. There are other tax rules that apply to the sale and purchase of personal residence.
3. Greater Value. In order to employ an exchange, the property you are exchanging for the property you wish to sell must be equal to or of greater value. For example, if you have a property valued at $1 million with financing of $700,000, you must exchange this property for one that is worth $1 million or more, with financing of $700,000 or more.
An interesting variation on this rule is that it does not just have to be one property. You can identify several properties as long as the total value of ALL the properties exceeds the value of the property you are selling.
If you choose to exchange for a property of lesser value, such that once the transaction is complete and you receive cash proceeds, that cash will be subject to capital gains tax. This is called a partial 1031 exchange.
4. Same Owner. The owner of the property being sold must be the same as the owner of the property being purchased under the exchange. You cannot sell a property that is held personally and have an LLC as the owner of the property purchased.
5. 45 Day Identification Period. Once the seller has closed on the sale of his property, he has 45 days to identify up to three properties that he wishes to purchase. You can identify up to four properties, provided that the total value of the four properties does not exceed 200% of the value of the property sold.
6. 180 Day Purchase Period. The purchase of one or more of the identified properties must be completed within 180 days OR the due date of the seller’s tax return (with extensions) for the year that the property was sold, whichever is sooner.
Now that we know what the rules are, let’s see how they apply to our example. The first thing we do is calculate the cost basis for the property that is being sold. Suppose that improvements were made to the property in the year prior to the sale, in the amount of $20,000.
The property is sold on June 30, 2019, for $150,000. The 45-day clock starts ticking. Several weeks later you identify another property with an asking price of $200,000.
For the purposes of this example, let’s assume that there was a first mortgage on the property sold of $80,000. Therefore the net proceeds were ($150,000 – $80,000) $70,000.
In order for the 1031 exchange to be totally tax-exempt, the entire $70,000 in proceeds (net of costs) must be applied to the purchase of the new property.
Let’s assume that the closing costs for the purchase of the new property are $10,000. The proceeds net of closing costs is $60,000. This must be applied as the down payment of the new property, resulting in a new mortgage of $140,000.
The deal must now be closed before December 31 in order to fully qualify or the exemption.
As mentioned previously, a 1031 exchange is essentially a tax deferral, not a tax reduction or exemption. The 1031 exchange reduces the cost basis so that if the property is sold later without incorporating another 1031 exchange, the full capital gains tax will have to be paid at that time. Let’s take a look at how this works for our example.
We previously calculated the cost basis of the property that was sold to be $107,400.
The property was sold for $150,000 and a new property was purchased for $200,000.
Closing costs on the property purchased was $10,000. Let’s do the math.
To better demonstrate the consequences of the new adjusted cost base, let’s suppose that the seller receives a full cash offer of $220,000 several months after the closing of the property purchased. Should the seller choose to accept the offer without utilizing another 1031, the capital gain on the sale would be $220,000 – $167,400 = $53,600 and would be taxed accordingly.
What is the Cost of a 1031 Exchange?
There are 4 types of exchanges and there are different costs associated with each one.
1. The Simultaneous Exchange
This exchange is where the property sold and the property purchased must close on the same day. In this type of exchange there are no additional costs other than the typical closing costs of any real estate transaction. This can be risky as issues can arise which may delay the closing of one of the deals. The tax advantage of the exchange would be lost.
2. The Delayed Exchange
The delayed exchange is the most common type of exchange. The seller sells his property and then identifies the property he wishes to purchase and closes the deal within the 180 day period. This type of exchange requires the services of a Qualified Intermediary.
What is a Qualified Intermediary?
A qualified intermediary is an independent third party that holds the net proceeds from the sale of the property to be exchanged until such time that the replacement property is identified and purchased. At the time of closing, the escrowed funds are released to the seller of the replacement property.
What are the fees for a qualified intermediary?
The fee for the qualified intermediary is typically between $750 and $1200. However, if the seller of the property to be exchanged identifies more than one property, the qualified intermediary may charge an additional $300 – $500 per property identified.
In addition, the qualified intermediary will place the net proceeds into an interest-bearing escrow account and will collect the interest earned during the escrow period as part of his fee.
It is important to understand the entire fee structure that a qualified intermediary may charge. The initial upfront fee may appear to be attractive but additional hidden fees could make the final cost much less attractive.
Why Do I Need A Qualified Intermediary?
Under IRS tax rules, you are not deemed to have earned income or a capital gain until you have actually received a payment. If you have not received a payment, even though you may have a contractual agreement to receive the payment, no tax is owed.
In keeping with this principle, the qualified intermediary is required so, that in effect, you never receive the cash directly and as such, it is not taxable.
3. Reverse Exchange
As the name suggests, this type of exchange is where the seller first identifies and purchases the property and then sells the property he wishes to exchange. This may sound simple but it is, in reality, more difficult and more expensive. This type of exchange usually requires an all-cash deal as lenders are extremely reluctant to finance this type of exchange.
To make matters worse, the qualified intermediary will charge significantly more for this type of exchange, usually between $3,500 and $7,500.
Fees can vary among different states, so research the fee structures in your location.
4. Improvement or Construction Exchange
This type of exchange allows the seller of the property to be exchanged to use the escrowed funds to make improvements on the property he has identified and wishes to purchase. This type of exchange must adhere to all the rules of any 1031 exchange. You must complete any improvements within the 180 day period.
The fees for this type of exchange vary greatly, so it is prudent to consult with a qualified intermediary before proceeding with this type of exchange.
Advantages of a 1031 Exchange
The biggest advantage of a 1031 exchange is for those sellers who have held their property for a long period of time and experienced substantial price appreciation during that time period. A simple sale can have significant tax consequences, particularly if you are in a high-income bracket. The long term capital gains tax rates are illustrated below.
Disadvantages of a 1031 Exchange
There are primarily 2 disadvantages of a 1031 exchange;
1. Pressure to identify an alternative property within the 45 day period. This can be particularly significant in a hot market and might force the seller to either settle for something less than ideal or to overpay for a replacement property. Either way, you to determine if the tax savings of the 1031 exchange are worth the trade-off.
2. Over time, a 1031 exchange can become a tax trap, especially if the exchange is done several times over a long period of time. Couple the exchange with several mortgage re-financings and the seller could find himself in a situation where the taxes owed on a straight sale of the property could exceed the equity he has in the property. I have illustrated this below.
With each exchange, the adjusted cost basis declines as a percentage of market value. There are strategies available that could reduce the risk of being put in a position where you do not have the cash or the equity to pay the taxes.
You should consult with a tax attorney or tax professional if you intend to follow this path.
This information is provided for educational purposes only and is not to be construed as professional advice. Please consult with a real estate attorney for any legal questions, or a tax accountant for any tax-related issues that you might have. Every situation is unique and may require specialized advice.