1031 exchanges offer business owners and real estate investors a solution to a “good” problem. When you buy an asset such as a warehouse, office building, rental apartment or piece of land, it will likely increase in value over time. When you sell it for a profit, there's usually a hefty tax bill that must also be paid. Those taxes eat into the money you earned on the transaction, which in turn leaves you with less cash available to reinvest in a new property. To solve this problem, Congress passed legislation nearly 100 years ago allowing for the deferral of taxes on the sale of certain property when the proceeds are used to purchase similar property. A 1031 exchange can offer tremendous advantages over a regular sale. The name refers to the section of the IRS tax code that permits the transaction.
What Property Qualifies?
The IRS is most interested in making sure the property you're selling and the one you're buying are both “held for productive use in a trade or business or for investment.” You can’t exchange your home for a new house or your apartment for a Lamborghini. The properties don’t need to be identical either. You can exchange a warehouse for a rental apartment, a piece of undeveloped commercial land for an office building, or a small apartment complex for large rental house. It also doesn’t have to be a one-to-one transaction. You can sell a strip mall to buy eight different rental apartments in four different cities.
While almost all 1031 exchanges involve real estate, the transaction can be used for other kinds of “real” assets; it isn’t permitted for stocks, bonds, notes or other securities.
To obtain the maximum tax benefits, the new property has to be worth as much or more than the old property, and the amount of mortgage debt on the new property must be as much or more than the amount of mortgage debt on the old property.
How Does the Timing Work?
The IRS will give you a window of time to complete the transaction but is strict in enforcing it. From the time you close on the sale of your property, you have 180 days to complete the 1031 exchange. Otherwise, you lose the tax benefits of the transaction.
The IRS does recognize that many times owners will sell before actually finding the new property they want to buy. The IRS provides a 45-day window from the closing date of the sale of your property to identify the new property you want to purchase. There are some complicated rules associated with identification you must understand before proceeding with a 1031 exchange.
Who Can Help Me?
The IRS requires that a neutral third party known as a Qualified Intermediary (“QI”) be contracted to execute the 1031 exchange. This is usually a bonded and insured business dedicated to facilitating 1031 exchanges. You can’t use your friend, your family lawyer or a business partner; the QI must be independent.
The QI will review your proposed transaction, prepare the necessary tax documentation, communicate with the other parties involved, hold the money in escrow for both the sale and the purchase, and oversee the process of transferring the old property to the buyer and new property from the seller. The QI industry isn’t regulated, so it’s important that you work with a reputable and established QI firm, given that they'll be handling your paperwork, your properties and your money.
How Much Does It Cost?
The main cost associated with a 1031 exchange is the fee charged by the QI, which can vary from several hundred to several thousand dollars depending on the complexity of the transaction. The tax savings can more than offset this fee.
How Exactly Does It Work?
Let's use an example to illustrate: John owns a warehouse, which he purchased for $300,000 in cash 20 years ago, and over the years spent another $50,000 improving. He rents out the warehouse for $2,000 per month. Because of its location, the warehouse has appreciated in value significantly and can now be sold for $550,000. His plan is to sell the warehouse, take his cash and put a down payment on an apartment building, which will generate sufficient rental income for him to retire. To do this, he needs $500,000 for a down payment on the new, more expensive property.
If John simply sells the warehouse, his dream of retirement would probably come to a sudden end because of the taxes due. In a regular sale, John would be responsible for paying three taxes: (1) depreciation recapture-related income taxes, (2) federal capital gains taxes, and (3) state capital gains taxes.
Depreciation recapture-related income taxes
John was able to depreciate the value of his warehouse as a business asset. Over the years he has owned it, John claimed a total of $160,000 in depreciation. This basically lowered his taxable income by that same amount. By selling the building at a profit, the IRS is claiming, “it looks like the property didn’t really depreciate in value, so you need to pay us the income taxes you avoided over the years by using depreciation.” The IRS charges a flat 25 percent tax on the amount depreciated. John would owe $40,000 in depreciation recapture-related income taxes.
Federal and state capital gains taxes
Federal long-term capital gains tax rates vary from 0 percent to 23.8 percent, depending on your tax bracket. State long-term capital gains also vary from 0 percent to 13.3 percent. After taking into account typical tax rules such as the deductibility of federal taxes on state returns, the average combined top marginal capital gains tax rate is 28.7 percent. Using this figure, John’s capital gains would be calculated as follows:
(Sale price - (original purchase price + capital improvements – depreciation) – selling costs) x rate = Capital gain tax liability
In John’s case, it would be: ($550,000 – ($300,000 + $50,000 - $160,000) - $20,000) * 28.7% = $97,580.
John’s total tax liability from a sale would be $40,000 + $97,580 = $137,580. Taking into account the $20,000 in selling costs would leave him with net cash of: $550,000 - $137,580 - $20,000 = $392,420. This is over $100,000 less than he needs to purchase the apartment building.
If John executed a 1031 exchange, the outcome would be quite different. While he would still owe the taxes described, the IRS allows him to defer those taxes indefinitely by using the proceeds of the sale to purchase the apartment building. He would receive the full $550,000 sale price minus the $20,000 in selling costs and a small fee of $1,000 to set up the exchange. This would leave him with more than the $500,000 in cash needed for his apartment building down payment. If John decides to execute a similar transaction 10 years from now, he can do so and once again defer the taxes due.
Do It the Right Way
While 1031 exchanges have many benefits, the IRS can be very picky when reviewing how they were executed and can deny you the tax benefits of the transaction if it was not set up correctly. It’s important that you work with your accountant, tax advisor and legal advisor before proceeding with a 1031 exchange. It’s also extremely important to work with a seasoned Qualified Intermediary who will do the job exactly as required.
Read more about small-business taxes.
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