IRC Section 1031 allows investors to trade investment properties and defer capital gains tax as well as the 3.8% Net Investment Income Tax (NIIR) again and again until they eventually cash out. Keeping this money working for YOU over your investor life can make a huge, positive impact to your net worth at retirement.
It has been said that if you ever plan on purchasing an investment property, you should never sell one. This is because if you sell an investment property, you will be assessed a capital gains tax on the gain, or profit. The simple formula to calculate the gain is Net Sale Price - Adjusted Basis = Gain. The Net Sale Price is the Gross Sale Price less any selling costs. Your adjusted basis will be the initial cost plus any capital improvements less accumulated depreciation. Depending on your income, you could be assessed from 0% to 20% on the gain, not to mention the 3.8% NIIT for some investors. And these are only the federal taxes that might be assessed. Some states may also impose taxes on capital gains.
If you “sell” an investment property, you will be left with some fraction of the proceeds after taxes, which is acceptable if you are planning on using the proceeds to fund your lifestyle, or kids’ college. However, if you ever plan on buying another investment property, consider “exchanging” it for the other investment property as allowed under section 1031 of the IRC. If you exchange the investment property for another investment property, you will be able reinvest 100% of the net sale proceeds into the new property, thereby turbocharging your growth.
There are many reasons why an investor might trade one investment property for another. The most common reasons that I have seen are trading up or over. If your equity has increased significantly in your current investment property, you may be able to trade up into a bigger and better opportunity and increase your return on equity (ROE). if you find yourself dreading the next maintenance call on your apartment or gross full-service office investment, you might consider exchanging into a net leased investment with fewer, or no, landlord responsibilities. Other reasons could include political and geographical issues, or you received a “too good to refuse” offer on your vacant land. Or maybe you’re just a deal junkie. In any event, a like kind exchange could be your solution.
Before we continue, let’s define some common terms you will need to know.
Like Kind – this does not mean that if you are relinquishing a residential investment property that you must replace it with a residential investment property, or retail investment for retail investment. All real estate investments are considered “Like Kind”. The replacement property must also be held for investment purposes. It cannot be your residence or personal property.
Downleg – in a “Delayed Exchange”, which is the most common type of exchange, the downleg refers to the property you are relinquishing.
Upleg – refers to the replacement property in a ”Delayed Exchange”.
Qualified Intermediary (QI) – the main role of the QI is to hold the sale proceeds from the relinquished property in trust to fund the replacement property. If you take possession of the funds, taxes will be due. You cannot have a financial relationship with your QI:this excludes family members including your spouse, children, siblings, and parents. Also excluded are business partners and any other individuals that you have a direct financial relationship with. We will discuss who should be your QI shortly.
There are six primary types of Like Kind Exchanges under IRC 1031. They include;
In this article we will focus our discussion on the Delayed Exchange because it is the most common of all the types of exchanges.
The first thing you should consider if you are thinking about exchanging an investment property is your QI. Earlier we briefly mentioned who can’t be your QI. Now let’s discuss who SHOULD be your QI. I have seen 1031 exchanges where the QI was a trusted friend of the investor. While this is allowed, it is not recommended.
1031 exchanges can be complex, and there are professionals who specialize in them. The first thing you should consider is experience. Choose an attorney who specializes in real estate or tax law and has a successful track record of completing tax deferred exchanges, or choose a title company that specializes in them. A reputable and experienced QI will facilitate the entire exchange from handling the sale of the downleg, holding the proceeds, ensuring compliance, handling required documents such as exchange agreements, assignments and notices, and ensuring the funds from the downleg are used to fund the upleg. A side benefit is that you will keep your close friendships intact.
Next, you should engage an investment real estate broker who is experienced in executing 1031 exchanges. Due to the tight timelines in the exchange process, having an experienced broker on your team can make the difference between a successful transaction and a large tax bill. In addition, the right broker can ensure that your upleg is the best replacement property available at that time for your unique situation.
Now that you have your QI and your broker engaged, you can complete the downleg phase of your exchange. Once you close on the downleg, you will have 45 days to identify your upleg. As you would expect with the IRS, there are specific rules you must follow.
The Three Property Rule allows the investor to identify up to three replacement properties regardless of value. This allows the investor to have a plan B and plan C if plan A falls through for any reason.
The 200% rule allows the investor to identify more than 3 properties as long as the total value of all the properties does not exceed 200% of the value of the relinquished property. This is useful if the relinquished property is so substantial that it will take multiple acquisitions to complete the exchange.
The 95% rule says that if you identify more than 3 properties, and the value exceeds 200% of the relinquished property, the investor must close on 95% of the total value of all the identified replacement properties. We don’t see this rule come into play very often.
The 180-Day Rule – The investor has 180 days from the closing of the relinquished property to complete the exchange including closing on the replacement property and transferring ownership.
With these rules in mind, ideally your broker will gain a deep understanding of your exchange criteria very early in the process, well before you complete your downleg phase. Once you are under contract with your downleg, your broker should be very familiar with the available inventory of replacement properties that check your boxes. He/she should be reviewing options with you during this time so that you are ready to move forward as soon as the contract on your downleg becomes non-refundable.
Many sellers are not willing to commit to a purchase and sale agreement that is contingent upon the sale of another property unless the other property is under a firm contract with non-refundable earnest money. This means that if you begin trying to negotiate on your upleg too early, your choices will likely be limited. In the early stages, prior to beginning negotiations, you and your broker should be able to do enough investigating to determine which of the available opportunities best fits your needs and minimize the risk of unpleasant surprises.
At the appropriate time, you and your broker should begin negotiations on your top 3 replacement candidates under the Three Property Rule, or however many properties under the 200% or 95% rules. Having multiple options for one acquisition can absolutely put you in a stronger negotiating position.
While some buyers will put multiple properties under contract and close on only one, they run the risk of getting a reputation of being a low probability buyer. I prefer to get very comfortable with the best option, then move forward to a contract while keeping in touch with the other owners or brokers along the way. If you conduct yourself honestly and transparently, you will find the other sellers and/or their brokers quick to jump into a deal with you if your first choice goes sideways.
In the ideal situation, you will move smoothly and painlessly through due diligence and on to closing on your first and best option. If the deal blows apart, you should still have time to start fresh with your new first choice. Remember, you don’t have to close your upleg in 45 days. All you are required to do is identify a replacement. You should identify the maximum number of replacement properties under the rules. This will give you a potential back-up deal if something goes awry after the 45 day identification period. Keep in mind that if you identify more than three properties that collectively exceed 200% of the value of the relinquished property you will be required to close on at least 95% of the value of all the identified properties. This is very hard to accomplish, and nearly impossible if you don’t have continency contracts on all the identified properties.
Like Kind Exchanges under IRC 1031 offer an effective way to defer taxes and reinvest proceeds into new properties. This can help you to optimize your real estate portfolio, grow your assets, and diversify holdings.
However, successful exchanges require careful planning and execution. Ensure you work closely with your qualified intermediary, broker, attorney, and CPA to comply with regulations and to fully leverage the benefits of a 1031 exchange.
Whether your goal is to improve your ROE, geographically relocate your investments, transition to a different property type, or simply expand your portfolio, a well-executed exchange can help you achieve your financial goals. Assemble your team and plan your strategy to take full advantage of this useful investment tool.
Doug Molyneaux, CCIM, is the principal broker for the Molyneaux Group, a commercial real estate investment brokerage firm based in Biloxi, Mississippi. He advises owners and investors of commercial income properties on how to maximize their investment yield and mitigate their risk. He can be reached at 228.273.1660 or by email at [email protected]. Learn more at www.molyneauxgroup.com. In addition, Doug is a commercial real estate performance coach at The Massimo Group, North America’s foremost coaching firm focused on the commercial real estate community. Learn more at www.massimo-group.com.
