1031 Exchanges – A Basic Overview

1031 Exchanges – A Basic Overview

1031 exchanges have a huge impact on the real estate market. I was recently looking at a property for Scheer Partners to acquire but lost out to an out of town buyer who had to complete a 1031 exchange. My uncle recently sold his home in Maryland and bought a new one in California with 1031 money. Congress has even been talking about eliminating them in their tax reform package, although it appears they will remain solely for real estate transactions.

1031 exchanges account for approximately 30% of annual real estate transaction volume. Analysts estimate that eliminating the program would result in a short-term drop of 4.6% – 8.0% in property values.

Clearly the 1031 exchange program is bigger and has a greater impact on the real estate market than one might have anticipated so I decided to speak with David Christopher, CPA at our accounting firm, Santos, Postal & Company, P.C. (www.SantosPostal.com) for some more insight on how 1031 exchanges work and how they impact investors such as myself.

Can you quickly explain a 1031 exchange?

A 1031 exchange occurs when you have a sale of business or investment property (in most cases, real estate), in which you would normally have a taxable gain, but because you are reinvesting the proceeds of the sale in a “like-kind” (i.e., similar) property as part of a 1031 exchange, the gain on the sale is deferred.

A common misconception is that this is a tax-free transaction. Depending on future events, it could turn out to be tax-free, but initially, it is simply a deferral of the tax. Also, depending on the exact circumstances of the transaction, there may still be some gain that is taxable in the period of the exchange. For instance, if cash, or “boot,” as it is often called, is received, or if your debt on a property is reduced via the exchange, taxable gain may be recognized.

Why would an investor with 1031 money be able to offer a higher purchase price than an investor without it? Can you give some numerical examples?

Let’s look at two basic examples:

Example 1: Investor A sells a property worth $1,000,000. He has hired a Qualified Intermediary and they have identified a property he plans to exchange it for with a value of $1,000,000, owned by Investor C. In this transaction, ignoring brokerage costs, fees, and any other buying and selling expense, he will not need to come out of pocket at all for the new property. He will have no taxable gain.

Example 2: Investor B recently sold a property for $1,000,000 that had a gain of $200,000.  He wishes to use his proceeds to purchase the same property from Investor C as illustrated in Example 1 above. However, because he had a taxable sale and will need to pay taxes on the amount of the gain, he needs to retain some cash to pay the associated taxes (we will assume a 25% combined tax rate, so $50,000). Therefor

Are there any limits to how much money someone can save or who can take advantage of this program?

There is no limit to how much tax you can defer with a section 1031 exchange. If you are exchanging like-kind property with values in the billions that would have taxes of millions, it is fair game. The primary limitation is that you must identify a like-kind property to consummate the exchange within 45 days of your property sale; and, then you also need to close on the new purchase within 180 days of your property’s sale. Also, while the definition of “like-kind” property is vague, cash is not like-kind to a building, providing another limitation. That said, land is considered like-kind to a building, or multiple buildings, so there is some flexibility.

There are other restrictions as well. As stated previously, 1031 exchanges are for investment or business property, not personal property. You cannot exchange your personal residence for another. And if you convert an investment or business property to a residential property and immediately put it to use as your personal residence, the IRS will disallow the transaction and all gains will be taxable.

What would you advise someone to do if they were selling a building and would soon have potential 1031 money to reinvest – what are the financial repercussions?

I would hope they have already consulted with their real estate broker, attorney, and certified public accountant. If not, these should be their next phone calls. Hopefully, a seller has already called the required professionals and is using a Qualified Intermediary for the sale, as well as keeping the sales proceeds in escrow. If they sold the property and have already received the proceeds or had a note paid off with the proceeds, it is too late to retroactively turn this into a 1031 exchange. The financial repercussions could be enormous as they would be liable for taxes on the gain of the sale. Assuming they were proactive and listened to their professional advisors, I would advise them to move quickly in identifying a property to acquire as there are tight deadlines, both in identifying the exchange property and for closing on the purchase. If they can identify a property and make a purchase within the allotted time period, they would be able to defer most, if not all, taxes due from their original sale, and the financial repercussions would be negated.

Please note, these decisions need to be looked at from more than purely a tax planning mindset. If you are buying a property through a 1031 exchange only to defer the taxes on a gain, but the new property turns out to be a poor investment, the cash flow implications over time could be worse than had you simply paid taxes on the gain of the original sale.  Therefore, it is important for the investor to properly analyze and perform due diligence in their search for a new investment property.

Make sure this process is thought through completely. There are too many rules and guidelines to explain in this limited space.  In our experiences, we have seen 1031 exchanges get reversed for errors made and misunderstandings on the part of the client or the Intermediary. If your readers learn nothing else, it is always wise to consult with professionals before attempting to engage in a Section 1031 exchange.

If you have questions about where to start, please feel free to contact me at mbrown@scheerpartners.com or contact David Christopher at either DChristopher@SantosPostal.com or 240-499-2067. We would be more than happy to discuss the process with you in greater detail.

Posted by Matt Brown, Acquisitions Analyst, with insight and thought leadership provided by David Christopher, CPA

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