Making the 1031 Exchange Work for You

It’s not uncommon for property owners to face significant capital gains (and the consequential tax) in the sale of real estate, either through accumulated depreciation or appreciating asset value, or the combination of both. Rather than pay the capital gain tax and reinvest the difference in another property, the 1031 Exchange allows the taxpayer to replace the property with an ‘exchange’ into another ‘like-kind’ property and essentially defer the payment of the capital gain tax by adjusting the basis of the newly acquired property.

Just over 15 years ago, the Internal Revenue Service instituted the long-awaited rules on deferred exchanges. Section 1.1031 of the Internal Revenue Code details the procedure for turning a sale/purchase transaction into an exchange. The opportunity to defer the payment of capital gains tax is available to owners of investment real estate if the owner intends to re-invest the equity of the sale of another real estate investment.

This deferment results in more equity to invest in the new property and allows the taxpayer to acquire a more substantial investment than had the original property been sold, and the capital gain tax paid.

How it Works

A properly structured 1031 exchange allows an investor (1) to sell a property; (2) reinvest the proceeds in another property; and (3) defer the capital gain taxes. This procedure allows for real estate portfolio growth while protecting the investor from capital gain taxes. Let’s say that an investor incurs $70,000 in combined taxes (depreciation recapture, federal capital gain tax) on a $200,000 capital gain. The investor has two choices:

• The investor incurs the $70,000 tax burden and reinvests the remaining $130,000. Assuming a 20% down payment and an 80% loan-to-value ratio the investor can purchase a property up to $650,000;

• With the 1031 exchange, the same investor can transfer all of the $200,000 in equity. Assuming the same loan constraints, the investor is able to purchase up to $1,000,000 in real estate.

When using this strategy, the taxpayer acquires the new property with a reduced basis, which results in the ‘deferred’ tax being due when the investor eventually cashes out. However, in estate planning, if the taxpayer/investor wills his property to his heirs, they will receive the property at the value at time of death and the deferred tax may be avoided altogether. Thus the 1031 Exchange can be a powerful tool in equity-building for the investor and his estate.

Of course, as with any investment strategy, the advice of tax attorneys, accountants, and real estate brokers familiar with these procedures is critical to compliance with the tax code and the enjoyment of the tax-deferral strategy.

Know When to Say ‘When’

Sound good? How do investors know if they are candidates for an exchange?
First, any investor completing a sale should have his or her tax advisors calculate the federal capital gains tax that would be due should the property be sold at the anticipated sale price to determine how much actual tax ‘savings’/ ‘deferment’ is at stake.
Then the investor must identify a ‘like-kind’ property to acquire. There are rules as to what is like kind, so be careful. The rovision for real property is broad and includes land, rental, and business property. Alas, no, you cannot exchange investment property for a personal residence for your retirement home.

Know Which Exchange is Best

There are various types of exchanges such as simultaneous, delayed, reverse, and an improvement exchange. Often, there is need for an ‘intermediary’ to hold title for either acquired property or the relinquished property to satisfy the rules. There are firms that specialize in providing such a service and can be thought of as an escrow agent for titles. They are known as ‘qualified intermediaries.’ They provide the safe harbor for title.

Various exchange arrangements call for different time limits for acquiring and relinquishing title to the involved properties. Also, the identification of the replacement property can be made several different ways.

Again, it is imperative to engage experienced professionals to ensure compliance and a valid transaction.

If an investor is facing a relatively significant capital gain tax in the sale of property, and desires to defer the tax burden, then it would be worthwhile to investigate and evaluate the 1031 Exchange opportunity.

Bob Greeley is owner of R.J. Greeley Company, LLC, a full-service real estate firm with extensive experience across the spectrum of commercial, industrial and telecommunication real estate transactions; (413) 734-7923