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1031 Exchanges

1031 Exchanges...the Alternative to Taxes

As with any investment, there often comes a time when, for one reason or another, you need to sell your rental property. Perhaps your property has become a maintenance nightmare, the neighborhood has declined, the property has reached it's appreciation potential, or you've identified a better property elsewhere. Whatever the case, the next logical step is a sale.

However, the problem with a sale are those killer taxes which often take a huge bite out of your proceeds. This is where a swap, or 1031 exchange, can save the day. In simplest terms a 1031 exchange allows you to swap rather than sell, thereby deferring taxes indefinitely. Barrett-Eastman has conducted many 1031 exchanges for its clients and without exception they have been positive.

You should consider a 1031 exchange if:

For more information on 1031 exchanges check out the following articles:

7 Steps For A Successful 1031 Tax Deferred Exchange+

Step 1: Consult with your Tax and Financial Advisors to determine if a tax deferred exchange is appropriate for your circumstances and compatible with your investment goals.

Step 2: List the relinquished property for sale with a licensed Real Estate Broker.

Step 3: Offer, Counter Offer, and Acceptance. The Exchanger enters into contract with the Buyer for the sale/exchange of the Relinquished Property. The broker/agent discloses the Seller/Exchanger's intent to exchange into the purchase agreement and Receipt for Deposit.

Step 4: Open Escrow for the Relinquished Property and Coordinate with the Qualified Exchange Intermediary ("Intermediary"). The Intermediary prepares the exchange agreement and coordinates with the escrow holder to close escrow as Phase I of a tax deferred exchange. Important: The exchange agreement must be in place and signed by all parties prior to the close of escrow. Additionally, all earnest money deposits should be placed with the title company.

Step 5: Replacement Property Identification. After closing escrow for the sale of the Relinquished Property, the Exchanger must identify all Replacement Property within 45 days.

Step 6: Contracting for the Replacement Property. After closing on the Relinquished Property the Exchanger has 180 days to acquire the Replacement Property. With the help of his or her agent the Exchanger enters into a contract to purchase the Replacement Property from the Seller. In the contract to purchase, the agent discloses the Exchanger's intent to complete the exchange and obtains the Seller's cooperation.

Step 7: Open escrow for the Replacement Property. The Intermediary prepares the Exchange Agreement and coordinates with the Replacement Property Escrow holder. The funds held in trust by the Intermediary are placed in escrow and the Replacement Property is purchased by the Intermediary from the seller. The Intermediary then transfers the Replacement Property to the Exchanger and the transaction is closed to complete the exchange.

IRS Rules for 1031 Tax-Deferred Exchanges+

These are only highlights of 1031 exchange rules and regulations. Call your accountant or Exchange Intermediary for more information.

  • There must be an exchange between parties.
  • Must be Like-Kind: Farms, Ranches, stores, offices, warehouses, hotels, motels, shopping centers, industrial, apartments, bare land, rental houses: any "...property (real estate) held for productive use in a trade or business for investment." All are inter-exchangeable.
  • Cannot be Non-Like-Kind: Real estate contracts (installment sales), personal residence, vacation homes, personal property, stock-in-trade (developer property), stocks, bonds, interests in partnerships. Personal residences and vacation homes can be converted to investments.
  • Time Requirements: "Clock" starts the day that the first escrow closes. Target properties must be identified within 45 days; must be in writing; not necessary to have earnest money on ID property. Exchange period ends 180 days after "clock" starts (including 45 day ID period). No exceptions, no extensions, Saturdays, Sundays and holidays count! An exchanger must have a Qualified Intermediary and exchange documents in place before the first escrow closes.
  • Identification Rules: Must be written, signed and delivered to Qualified Intermediary (exchange facilitator or accommodator). Three property rule: exchanger can ID three properties of any value. OR 200 percent rule: exchanger can ID any number of properties as long as the combined fair market value does not exceed 200% of the relinquished property.
  • Related Parties: There is a two year holding period on exchanges between related parties -- certain blood relatives; most corporation or partnership interests; most agents of exchanger (anyone in a fiduciary relationship who must follow the instructions of the exchanger).
  • Actual or Constructive Receipt of Funds: Funds must be in "substantially limited access." Exchanger or his "agent" cannot receive exchange funds. Certain restrictions apply as to how and when funds are to be used or released to exchanger.
  • Full Tax-Deferred Exchange: All capital gain taxes will be deferred if fair market value, equity and mortgage values are ALL equal or are increased.
  • Partial Tax-Deferred Exchange: Any value that decreases is "boot" and subject to taxation but only to the extent of the "boot." A very popular type of exchange -- used to retain some cash.
  • Future Construction: A "build to suit" exchange can apply to new construction or remodels. The 45/180 rule applies. The Qualified Intermediary will hold title to the property until construction is complete.

1031 Tax Deferred Exchange Equity & Gain Worksheet+

Calculate Net Equity:

Market Value: __________________

Less Selling Costs*: __________________

Less Loan Balances: __________________

Equals Net Equity: __________________

(This amount will be reinvested in a replacement property in a full tax deferred exchange)

Calculate Capital Gain:

Market Value: __________________

Less Selling Costs*: __________________

Equals Exchange Value : __________________

(Minimum value of replacement property in a full tax deferred exchange)

Less Original Basis**: __________________

Equals Capital gain (even with a loss): __________________

Multiply by Cap Gains Tax Rate (usually 20%) : __________________

Equals Capital Gains Tax Due on Sale: __________________

Calculate Depreciation Recapture

Original Basis (from above): __________________

Less Adjusted Basis***: __________________

Equals Depreciation Recapture: __________________

Multiply by Applicable Tax Rate (usually 25%): __________________

Equals Depreciation Recapture Tax Due on Sale: __________________

Calculate Total Taxes Deferred:

Capital Gains Tax Due on Sale: __________________

Add Depreciation Recapture Tax Due on Sale: __________________

Equals Total Taxes Deferred with a 1031 Exchange: __________________

* Use 8% to 10% as an estimate for brokerage, escrow and loan points; vacancy and fixup costs are additional. The listing broker can refine this estimate and obtain bids on fixup needed.

**Original Basis is the original purchase price

*** Adjusted Basis is the original purchase price, plus improvements, less depreciation. Basis is the starting point for determining all gain or loss.

Tax Rates will vary by State and Individual Brackets. Always consult your accountant or tax attorney on the advisability of entering into any real estate transaction or tax deferred exchange.

You should consider a 1031 Tax Free Exchange if:+

  1. You own older properties that have high maintenance expenses.
  2. Your properties have high tenant turnover or vacancy rates because of the neighborhood or the property.
  3. Your current financing is poor and a new, low interest rate loan is enticing -- whether on your present property or a new one.
  4. You plan to hold rental property for investment for at least several years.
  5. You would like to upgrade into a newer home or locate in a better appreciating area.
  6. Your depreciation is running out and you would like to acquire additional depreciable basis.
  7. Your property has reached its maximum value and you want to lock in your gains but not pay the taxes.
  8. You want to simplify and stabilize your real estate portfolio.
  9. Our strategy with these exchanges has been to purchase newer construction in what we think to be quality neighborhoods that we consider to be undervalued.

The Downside

  1. There will be a brokerage expense on the sale of 6% of the sales price. There is also an exchange fee paid to an escrow intermediary of around $500-$1,000.
  2. Fix-up and vacancy expenses during the sale process
  3. Purchase costs including closing and financing fees
  4. The paperwork during the sale and financing processes

While these are short term costs, in order to make them up, you need a long term commitment (at least 5 years) to owning investment property.

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