This post originally appeared on tBL member Joe Larkin’s blog The Joseph Larkin Blog and is republished with permission. Find out how to syndicate your content with theBrokerList.
If you plan on selling your real estate that has been held for productive use in a trade or business or for an investment, you should consider utilizing a 1031 exchange. Section 1031 of the IRS Code allows a taxpayer to replace their relinquished property in a like-kind exchange. Basically, a 1031 exchange is a procedure that allows a taxpayer to sell a property and reinvest the gain into another property deferring any capital gains tax that would otherwise be due.
Section 1031 of the Internal Revenue Code has been in effect since 1921. This provision allows a seller of real estate to “replace” their “relinquished” property in a like-kind exchange. A “like-kind” property is real estate for real estate. By way of example, a shopping center can be exchanged for an industrial property or an office building can be exchanged for an apartment building. The long-term capital gain is realized, but for tax purposes, it is not recognized at the time of transfer of title.
However, the amount of unrecognized gain of the relinquished property that occurs in the exchange reduces the depreciable basis of the replacement property. This reduction of the depreciable basis reduces the amount of cost recovery (depreciation) that can be taken during the holding period of the replacement property.
Paying the capital gains taxes on the sale of a long-term capital asset can be costly. In general, and in certain cases, taxes on highly appreciated real estate can be as much as 50% with an outright sale. Currently, the long-term capital gains tax can be as much as20%, the cost recovery recapture tax can be 25% of cost recovery taken during the holding period, the net investment income tax is 3.8% and the state capital gains tax can range from 0% -13.3% depending on the state the property is located in. In light of all of the taxes, a basic sale can significantly reduce the selling party’s net proceeds from the sale.
If a property sells for more than its depreciated value, you may have to recapture the depreciation. This means the amount of depreciation will be included in your taxable income from the sale of the property.
To receive the full benefit of a 1031 exchange, your replacement property must be of equal or greater value than the property relinquished. The seller must identify a replacement property for the assets sold within 45 days and then conclude the exchange within 180 days. There are three rules that can be applied to define identification. You need to meet one of the following:
· The three-property rule allows you to identify up to three properties as potential purchases regardless of their market value.
· The 200% rule allows you to identify unlimited replacement properties if their cumulative value doesn’t exceed 200% of the value of the property sold.
· The 95% rule allows you to identify more than three properties, BUT the total value of the properties identified cannot exceed 200 percent of the relinquished property’s value AND you’ve got to acquire 95 percent of the aggregate value of all properties identified.
The 1031 regulations state that you have exactly 45 days after the date of sale of the relinquished property to identify the replacement property and exactly 180 days from the original date of sale to complete the acquisition of the replacement property. There are no exceptions.
1031 exchanges carried out within 180 days are commonly referred to as delayed exchanges. At one time, exchanges generally were performed simultaneously.
If replacement property is of lesser value than the property sold, the difference (cash boot) is taxable. If the personal property or non-like-kind property is used to complete the transaction, it is also boot, but it does not disqualify for a 1031 exchange.
The presence of a mortgage is permissible on either side of the exchange. If the mortgage on the replacement is less than the mortgage on the property being sold, the difference is treated like cash boot. That fact needs to be considered when calculating the parameters of the exchange.
With a 1031 exchange, the real estate basis of the relinquished property is carried forward to the replacement property. This will continue to do so with all future subsequent exchanges. This can be quite advantageous when considering estate planning. When the property owner passes away, their beneficiaries receive a stepped-up basis, and the capital gains taxes are eliminated.
Having the ability to monetize your real estate and re-deploying all your equity into other real estate makes financial sense. You can exchange into other replacement properties, or into other options such as Delaware Statutory Trust (DST) or a tenant in common (TIC) investment.
An investor can also exchange into a publicly-traded REIT. The investor would receive a convertible bond with an interest-rate coupon paid once or twice a year each year. In addition, the issuer grants the bondholder the right to convert the principal into a fixed number of shares allowing the investor to sell the shares on the stock exchange.
The 1031 exchange is a fantastic tool that many real estate owners and investors have employed for years. It is used in a wide variety of transactions for deferring capital gains and maximizing the value of property equity. The process can be quite straightforward with guidance from a team of professionals that have the knowledge and expertise in taxation and strategic investment.
Every taxpayer’s situation is different and there is a lot to a 1031 exchange transaction. You should always discuss tax implications with your tax advisor and or your financial planner. You should also evaluate your business strategy with a knowledgeable real estate advisor who can offer strategic options.
Joseph Larkin, CCIM, MCR, SIOR
