I just finished teaching the Professional Real Estate Investor Class and one of my students had a great interest in learning about 1031 exchanges. I teach the ins and outs of a delayed exchange in the class, but thought I would open up the topic to all my readers and give you something to think about.
What is a 1031 exchange? A 1031 exchange can provide real estate investors with one of the best tax strategies for preserving the value of an investment portfolio and expanding it. By using an exchange, the investor is able to defer the recognition of capital gains taxes that would otherwise be incurred on the sale of an investment property. Now the investor can take the entire amount of the equity they have accumulated and purchase substantially more replacement property.
There are five types of exchanges: Delayed, Simultaneous, Build-to-Suit, Reverse, and Personal Property. In this article I’ll outline the two most common, Delayed and Simultaneous.
Delayed – also known as Straightforward Exchange:
This is the most common type of exchange. Certain IRS requirement must be met to structure a delayed exchange. This arrangement gives the investor the advantage of the full exchange period.
The process is 4 basic steps:
1) Open the exchange – an investor must open an exchange account with a QI (Qualified Intermediary).
2) Close the sale of the relinquished property – the QI will, through an executed assignment, assume the purchase contract and instruct the closing agent to deed the relinquished property directly from the investor to the new buyer. The proceeds from the sale are then sent directly to the QI. This protects the investor from the prohibited receipt of the funds.
3) Identification of replacement property – there is a 45 day deadline to identify the replacement property(ies). The investor must follow one of two rules in identifying the property. I) identify a maximum of three replacement properties without regard to their FMV (fair market value) – this is known as “The Three Property Rule”. II) The investor can identify more than three properties as long as the aggregate FMV doesn’t exceed 200% of the relinquished property value.
4) Acquire identified replacement property – this is known as the exchange period. Within 180 days the investor must close escrow on the identified replacement property(ies). The funds are then transferred from the QI directly to the closing agent.
A simultaneous exchange occurs when the relinquished property and the replacement property are transferred concurrently. Some investors erroneously believe that two transactions closing on the same day satisfies the exchange requirements. Although a QI doesn’t hold the funds in this kind of exchange, its function is critical to creating a trade that is fully compliant with IRS code 1031. The QI provides the essential paper trail for validation of the flow and structure of the transaction. This will ensure the “safe harbor” treatment of the deferral of capital gains.
I hope you can see the huge tax advantage to a 1031 exchange. It can also be daunting. Purchasing either more properties or a bigger property can add to management issues and may not be the desire of the investor. A TIC (Tenant in Common), can provide the investor the opportunity to go bigger and use those deferred taxes without more management responsibility. Part of my personal strategy is to exchange my rentals into TIC’s.
A TIC is a vehicle where an investor is permitted to pool their assets with other investors in the acquisition of like-kind replacement property. TIC’s are organized by syndicators to be essentially passive investment and repositories for proceeds of 1031 exchanges.
An investor can get into a TIC with a minimum equity requirement as low as $100,000, which will allow the investor to invest in a high quality, institutional grade property. A TIC also allows the investor to be in a diversity of properties and locations without the worries of management.
Taxes are part of our reality, they shouldn’t be why we made decisions but they should always be part of the decision making process.
I believe that they will be changes in our tax laws soon; there has to be. I don’t know what they will be so if you can take advantage of these rules it’s better to do it sooner because later may not be an option.