1031 EXCHANGE

1031

Section 1031 of the Internal Revenue Code (IRC) allows an owner of investment property to exchange property and defer paying federal and state capital gain taxes (15%+ applicable state taxes) if they purchase a 1031 like kind property following the rules and regulations of the Internal Revenue Code. This allows investors to use all of their proceeds from their sale to leverage into more valuable real estate, increase cash flow, diversify into other properties, reduce management or consolidate into one property.

1031 Tax Exchange

There is some confusion regarding what type of property qualifies for a §1031 tax deferred exchange. The Internal Revenue Code Section 1031 tax exchange states that “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 either for productive use in a trade or business or for investment.” 1031 like kind exchange property can include, but is not limited to, any of the following, provided it is held for investment:

- Single Family Rental
- Duplex
- Apartment
- Commercial Property
- Raw Land

For example, a single family rental can be exchanged for raw land, or apartments or a commercial building. In addition, properties can be exchanged anywhere within the United States.

DOES AN EXCHANGE NEED TO BE SIMULTANEOUS?

No, contrary to what most owners envision, a 1031 tax deferred exchange is rarely a two-party swap. Most exchanges are delayed exchanges, whereby the Exchanger has 180 days between the sale of the relinquished property and the closing of their replacement property. They must identify the potential replacement property(s) within 45 days from closing on their relinquished property.

1031 EXCHANGE

It is applicable whenever a property owner intends to SELL any property that is not their primary residence (and falls under the definition of like-kind) and plans to BUY another like-kind property within 180 calendar days following the closing of their relinquished property. Paramount to any exchange is a competent and experienced Intermediary. Asset Preservation is the entity which structures, consults, guides and documents the exchange transaction from beginning to end.

WHAT IS A §1031 EXCHANGE?

Thanks to IRC §1031, a properly structured exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC §1031 (a)(1) states:

"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 either for productive use in a trade or business or for investment."

To understand the powerful protection an exchange offers, consider the following example:

• An investor has a $200,000 capital gain and incurs a tax liability of approximately $70,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold. Only $130,000 remains to reinvest in another property.
• Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property.
• If the same investor chose to exchange, however, he or she would be able to reinvest the entire $200,000 of equity in the purchase of $800,000 in real estate, assuming the same down payment and loan-to-value ratios.

As the above example demonstrates, exchanges protect investors from capital gain taxes as well as facilitating significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the IRC. For instance, an accurate understanding of the key term like-kind - often mistakenly thought to mean the same exact types of property - can reveal possibilities that might have been dismissed or overlooked. API is your resource to obtain accurate and thorough information about the entire exchange process.

The benefits of IRC Section 1031 exchanges can be tremendous! Investors are often able to defer thousands of dollars in capital gain taxes, both at federal and state levels. If the requirements of a valid §1031 exchange are met, capital gain recognition will be deferred until the taxpayer chooses to recognize it. This essentially results in a long-term, interest-free loan from the IRS.

AN EXAMPLE

An investment property owner sells a rental property for $400,000. The owner originally purchased the property for $200,000. There is $200,000 of debt and the property has been fully depreciated.  The capital gain is approximately $350,000 (assuming 75% of the property is depreciable). If the investor does not do an exchange, federal capital gain taxes would be:

$150,000 (depreciation recapture)  x 25%	= $37,500
$200,000 (capital gain balance)     x 15%	= $30,000
$350,000 Capital Gain Taxes Owed	= $67,500

The state taxes owed (where applicable) would need to be added to the federal taxes due. Assuming the property owner sold in California, the following additional taxes would need to be paid:

The next comparison analyzes the value of the new property that could be acquired in a sale versus an exchange. The comparison assumes an investor makes a 25% down payment and finances 75% of the property (75% loan-to-value ratio).

SALE VS. AN EXCHANGE

This example illustrates that the real power of a tax deferred exchange is not just the tax savings – it is the increase in purchasing power generated by this tax savings!

ADVANTAGES OF AN EXCHANGE

1. Preservation of equity

2. Maximize return on investment

3. Increased cash flow from larger properties

REVERSE 1031EXCHANGE

A reverse exchange is the purchase of the replacement property prior to closing on the relinquished property. An investor may need to consider a reverse exchange in a seller's market, where properties are selling quickly and inventory is scarce. The most common variation (often called "parking the replacement property") involves the Qualified Intermediary first purchasing the replacement property. When the relinquished property is sold at a later date, the Qualified Intermediary completes the exchange by deeding the replacement property back to the Exchanger. It is especially crucial that the Qualified Intermediary has in-depth knowledge of the steps and precautions necessary in these complex transactions. Working with an investor's tax advisors and attorneys, API draws upon substantial experience with reverse exchanges to help lead the investor safely through a minefield of potential hazards.

PARKING ARRANGEMENTS

The Power of Strategy™ - "Parking Arrangement"
Brochure in a PDF File

Click Here to view the full text of
Revenue Procedure 2000-37 in a PDF File

PARKING ARRANGEMENT EXCHANGES:

SAFE HARBOR FINALIZED ON SEPTEMBER 15, 2000

Revenue Procedure 2000-37 (finalized on September 15, 2000) provides the framework to safely perform a reverse exchange (purchasing a replacement property before selling the relinquished property) or an improvement exchange (making improvements or building a new replacement property).