If you’re interested in investing, 1031 Exchanges are a wonderful, legal way to defer tax liability almost indefinitely. Sound good? Read on.
As always, when I write about investing or tax implications of owning real estate, I am simply sharing my opinion. If you are thinking of investing or have questions about taxes with regard to real estate, speak with your financial advisor and/or tax accountant.
The basics of a 1031 Exchange are simply this: you trade the equity (amount you own free and clear) in your property for the equity in a new property. Basic enough? Although it sounds simple, it can get pretty complicated.
To defer taxes, you need to exchange your current property for a property of equal or greater value. To the extent that you get cash out or reduce the amount you owe (called boot), you will have to pay capital gains taxes. Capital gains taxes are approximately 10-15 percent lower than income taxes, so that’s good, but if you want to defer all your tax liability, you need to trade properties with equal or greater equity and equal or greater debt.
So, what’s the benefit? Well, if you find someone who owns a property you’d prefer, and they prefer your property–and the properties have equal values and equal debt–you are allowed to trade without paying any taxes.
In recent years, a new chapter was added to the 1031 Exchange rulebook: the Starker Exchange. Prior to Starker, you had to either find someone who wanted your property or a number of individuals who all wanted to trade like properties. Think musical chairs except there are enough chairs for everyone: one, two, three, SWITCH.
In the post Starker world, you list a property for sale and sell it to an exchange accommodator, a middle man. The accommodator takes title to the property and sells it to a third party. The accommodator holds all the cash, kind of like an escrow account. You find a property you’d like to own and the accommodator buys it using your money. He or she then transfers the property to you to complete the exchange. You end up with a more desirable property and pay no taxes.
The clock is ticking on these transactions. After selling your property, you must identify the exchange property within 45 days and complete the purchase of the exchange property within 180 days or by the end of the tax year. However, the 1031 Exchange doesn’t have to be a one for one in terms of numbers of properties, just amount of equity and debt.
Let’s say you own an apartment complex. That’s a big investment, and therefore harder to sell than a single-family home. You could use a 1031 Exchange to trade your apartment complex for several single-family homes. Then, if you only need to liquidate (sell for cash) one of the homes, you only pay capital gains taxes on a single-family home, rather than on the value of the whole apartment complex.
The downside of 1031 Exchanges are these: 1. Accommodators charge a fee for their service. It’s a reasonable fee, but it’s a fee. 2. The income tax basis of your original property is carried to the new property. This means lower depreciation for the future, and when the property is ultimately liquidated, the capital gains will be increased by the amount deferred in the first transaction.
Income tax basis is the amount paid for the property plus capital improvements minus depreciation. The real benefit of a 1031 Exchange is that you basically get an interest-free loan from the Internal Revenue Service and State of California — you have more equity to invest in your next property because you’re not paying taxes on each transaction. As long as you have a long-term view of investing, 1031 Exchanges can be a great way to go.
This is a very simplistic summary of a very complex topic. You must have good real estate advice as well as a tax professional to work with you.
Next time I’ll write about disclosures – where there really is no such thing as TMI (too much information). If there’s something you would like me to write about or if you have questions about real estate or property management, feel free to contact me at firstname.lastname@example.org or visit our website at www.realtyworldselzer.com. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.