1031 Exchange Explained - Podcast

A 1031 exchange is a transaction in which a taxpayer is allowed to exchange one investment property for another thereby deferring the tax consequence of a sale. The transaction is authorized by section 1031 of the IRS code. Section 1031 states that quote, “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for either for productive use in a trade or business or for investment”, end quote.

Looking at the history of 1031 exchanges, section 1031 was originally adopted into the IRS code in 1921. The original guidelines have been refined over the past 70 years and final regulations were issued by the IRS in 1991.

So who is a typical 1031 exchange investor? A typical investor may be an owner of rental homes, an apartment building, raw land, farm land, or even a business owner selling a business which has an appreciated real estate component. Or a typical 1031 exchange investor could be an owner of an office, retail, industrial or other type of commercial property. Most owners usually have owned real property for a fairly long period of time and have built up significant capital appreciation.

Now we will take a look at some of the critical requirements for a 1031 exchange. To defer taxes under IRS section 1031, the investor must first acquire “like kind” property. The replacement property or properties must be held for investment or use in business and must be of equal or greater value including equal or greater debt on the replacement property or properties. The investor must not receive any cash or other benefits from the sale of their relinquished property which is known as constructive receipt. Finally, it is extremely important that the investor follow the strict 45 and 180 day timeline put into place for 1031 exchange by the IRS.

So what is like kind property? Like kind property may consist of a rental house or condominium, an apartment building, shopping center or warehouse. Like kind property could also be an office building, raw or unimproved land, leasehold interest or Tenant in Common or TIC interests. Like kind property is not, a personal residence, any type of security, a REIT, partnership interest or a property located outside the United States.

Some of the procedures put in place by the IRS to identify replacement property or properties are as follows….The property identification must be delivered to the qualified intermediary or QI within 45 days of the relinquished property closing date. It is important to point out that there is no extension granted for Saturdays, Sundays or even Holidays. Identifications must be in writing and must be site specific.

The investor or exchanger has 45 days to identify replacement property or properties and has 180 days to close on at least one of the identified properties.

Now that we have gone over what types of properties may qualify for an exchange as well as some of the important guidelines to follow, let’s look at an example of an actual 1031 exchange…. Property owner Bob originally purchased a duplex for $250,000 dollars five years ago. Tired of managing the property, Bob determined he would sell the property for $1 million dollars. Bob had existing debt on the property of $125,000 dollars and his basis in the property was $213,000 dollars after depreciation. Bob’s transaction costs on this sale were $70,000 dollars.

Taking a closer look at Bob’s tax calculations, on line one you will see that Bob originally purchased his duplex 5 years ago for $250,000 dollars. He had improvement of $200,000 dollars and the land was valued at $50,000 dollars. So his depreciation on a 27.5 year depreciation schedule was $36,363 dollars which gave Bob a basis in the property of $213,636 dollars.

Selling the property for $1 million, Bob was faced with a gain of $786,364 dollars. (That is derived from a $1million dollar sales price minus a $213,636 dollar basis). Bob’s tax liability was $9,090 dollars in depreciation recapture tax, $117,954 dollars in federal capital gains tax and $39,318 dollars in state capital gains tax with equated to a TOTAL tax liability of $166,362 dollars.

Bob had several scenarios to choose from…He could sell the property outright and pay the applicable taxes of $166,362 dollars which would leave him with $638,638 dollars to reinvest elsewhere. Or Bob could execute a 1031 exchange, defer the tax liability of $166,362 dollars and reinvest the net $805,000 dollars back into investment real estate.

If Bob were to opt for scenario #1 of selling outright and paying the taxes, and invested the after-tax amount of $638,000 dollars in an investment earning 7% for 7-years, he would have $1,024,488 dollars at the end of the 7 year period. Now if Bob opted for scenario #2 with a 1031 exchange, he would have $805,000 dollars to re-invest into real estate earning 7% for 7-years, in which Bob would come out with $1,292,654 dollars after the same 7 year period. A $268,166 dollar difference by executing a 1031 exchange.

We thank you for tuning into the 1031 exchange podcast with the 1031 Alternatives Group on “The 1031 Solution…a tax deferral strategy for highly appreciated real estate.”

This material is neither an offer to sell nor the solicitation to purchase any security. Purchases may only be made upon thorough review of risks in merits located with in the Private Placement Memorandum or Prospectus. Pictures located on this presentation are not current offering and are used for illustration purposes only. This presentation is for illustration purposes only and is not intended to replace any competent tax, legal or financial planning advice. Securities offered through Pacific West Securities, Inc. – Broker Dealer – Member FINRA/SIPC.