How to Maximize Cash Flow With a 1031 Tax – Deferred Exchange
A Possible Scenario for 1031 Exchange.
Let’s say you bought a residential character in the San Francisco Bay Area for $250K twenty years ago. Since the character is located in a good area, its value has appreciated to $1M. Over the years, you refinanced the original loan to consolidate your other debts and currently has a $300K mortgage on the character. Each month, you collect $3,000 of rent. After paying $1,800/month for the loan, $400/month for character taxes and $60/month for insurance, you net $500 of cash flow/month after paying character management and maintenance expenses.
As you grow older, you realize that you need a second source of reliable income so you are not completely dependent on your salary. You are also not happy with just $500 of cash flow a month on the $750K of equity in your rental investment. So when you see an attractive multi-tenant shopping strip in a middle-class Dallas suburbs, 100% NNN lease with $195K/year of Net Operating Income (income after all expenses except the mortgage payment) on the market for $2.6M offering 7.5% cap, you get excited!
Since the residential real estate market in the Bay Area has been very popular to sellers, you consider selling your rental character to buy this shopping strip. You calculate that you would have to pay about $250K in federal and state income taxes on $800K of capital gain ($1M less $250K buy price and selling fees, plus $50K in depreciation recapture). You just hate having to pay $250K to the government – money that may go toward your down payment on the shopping strip. There is a better way – a way to defer the income tax.
What is a 1031 Tax-Deferred Exchange?
Section 1031 of the Internal Revenue Code generally provides that neither gain nor loss is recognized if qualifying character is exchanged for other qualifying character of a like-kind. In the above scenario, you may defer the payment of $250K in both federal and state taxes if you acquire another investment character with equal or greater debt and equal or greater equity. In other words, if you buy another investment real character for $1M or more, using all of the net proceeds as down payment, then you may defer the $250K of taxes. Essentially, the government would lend $250K to you, without interest. And you may repeat this deferral and never pay income taxes.
How Do You Qualify for a 1031 Exchange?
You must comply with several strict rules. Failure to satisfy any of the rules will disqualify your transaction from a 1031 tax-deferred exchange.
- You must trade up. The character you buy (substitute character) must have an equal or greater debt AND an equal or greater equity than the character you sell (relinquished character). This method you must put all of the net proceeds from the relinquished character to the substitute character. The fair market value (FMV) of the substitute character must also be more than the FMV of the relinquished character.
- The qualifying character must be of like-kind. The relinquished and substitute similarities must be held for productive use in a trade or business or for investment, before and after the exchange. And one kind of character may not be exchanged for character of a different kind. for example, you may not exchange a residential rental character for one you intend to occupy as your principal residence – not qualifying character. And you may not exchange a factory for equipment – not like kind. however, residential and commercial real similarities are of like kind. So, you may exchange a residential rental character for a shopping center.
- In a delayed exchange, you must clarify the substitute character within 45 days and receive it within 180 days from the closing date of the relinquished character or by the due date of your tax return (with extension) whichever is sooner.
- You may clarify up to 3 substitute similarities and must close escrow with at the minimum 1 of the 3. Alternatively, you may clarify as many similarities as you want as long as the total value of these similarities does not go beyond 200% of the value of the relinquished character.
- You must acquire the character for investment purposes and not chiefly to resell for profit. While the IRS is silent about how long you have keep up the character before you can qualify for 1031 exchange. Most tax advisors believe that two years is an adequate holding period for investment purposes. You should check with your tax accountant if the investment period is shorter to make sure your 1031 can resist an IRS audit.
- You should have an exchange intermediary holding the sales proceeds of the relinquished character. Most investors use an exchange company as the qualified intermediary for a delayed 1031 exchange.
- If you exchange a character with a related person (your children, parents), then both parties may not dispose the similarities within 2 years.
- If the sale proceeds are deposited in an interest bearing account during the exchange, you must receive the interests AFTER the close of escrow of the substitute character.
What Expenses are Permissible?
You can use 1031 proceeds to pay for a certain selling expenses of the relinquished character and buying expenses for the substitute character: owner’s title insurance premiums, escrow agent or closing attorney’s fees, real estate broker’s commissions, 1031 exchange intermediary’s fees, document move taxes, record fees, and tax advisor fees. You cannot use 1031 proceed to pay for these expenses: loan fees/points, appraisal fees, mortgage insurance premiums, lender’s title insurance policy premiums, character insurance premium, repairs and/or maintenance costs.
Strategies for a Successful 1031 Exchange
The following strategies are intended for investors looking for commercial character as a substitute character.
- Have 3 plans for your 1031 exchange: A, B, and C with plan A being the best case and plan C being the worst case. Have at the minimum one different character for each plan.
- Start looking for a substitute character early. Since you have only 45 days to clarify substitute similarities, you should make an offer as soon as the relinquished character is in escrow. By the time you close escrow on the relinquished character, you should have one offer accepted on a substitute character. This first character does not need to be the most desirable character at the best price. Mentally, you should think of it as a plan-C character for the worst case scenario. That way, you don’t wait till the last minutes to make an offer. It is also intended to take away your worries so you sleep well, such as “Oh my God, what if I cannot find a substitute character?”.
- clarify more than 1 substitute character. If something unexpected comes up with your first choice, e.g. the soil is polluted, you have a plan B and plan-C similarities to fall back on.
- Specify a 30-day due diligence and cancellation period in the contract. This will give you more time to specify more than 1 character.
- Think twice about choosing a substitute character with loan assumption. It’s much harder to get lender approval for loan assumption than for a new loan. additionally, you have only once chance to get approval for loan assumption versus many chances to get a new loan approved. You don’t want to have your loan assumption denied by the lender after the 45 day identification period.
Questions for a 1031 Exchange Intermediary
Technically, you don’t need a 1031 exchange company to manager the exchange. However, it is advisable to have an expert assist you. This company will ensure that you comply with strict IRS rules. To decide which company to assist you, you should consider:
- The fee is around $500-$750 per transaction. The company that charges less tends to limit you to 3 substitute similarities and the company that charges more may not have that limit.
- Whether your proceeds will be deposited in a separate trust account where your money is FDIC insured or commingled with the company’s main account. In the event that the company goes under which some of them did during the recession, it’s easier to show the money in the separate trust account is your money and not the exchange company’s money.
- Whether your proceeds will earn any interests and the money is insured.
What if you want to buy the substitute character first?
For some investors, the strict 45 day identification period and 180 day exchange period may be too short. In addition, some investors would only consider doing a 1031 exchange only if they are to find appropriate substitute similarities. The different is to consider a reverse exchange in which the substitute character is purchased first before the relinquished character is sold. However, the substitute character must be owned by an intermediary party during the pendency of the like-kind exchange until the taxpayer is able to sell her relinquished character. Then the substitute character is exchanged to the taxpayer. A reverse delayed exchange is an progressive strategy with a different set of challenging issues not meant for average investors. You should consult a tax advisor to guide you.
What are some of the possible issues?
Due to the time limits in 1031 exchange, it’s possible that some people may want to take advantage of your situation. And so, you should mentally realize and accept the fact that as a 1031 buyer, you may not be in the best position to negotiate.
- There are sellers or listing brokers who feel very positive about 1031 buyers. They reason these buyers will have to buy and close escrow or have to send a big check to Uncle Sam. however, some sellers or listing brokers feel negative about 1031 buyers. They reason 1031 buyers will offer to buy 3 similarities and close escrow with one. And so, there is 33% chance the 1031 buyers will close escrow. And so for these sellers may not be receptive to your offers.
- Sellers know 1031 buyers have to close escrow. And so they may become less flexible in negotiation to 1031 buyers once the buy contract is executed. For example, you ask for repairs credit which they may agree to in normal transaction but may say no in a 1031 transactions. And so, it’s important to have back up similarities, just in case.
- Some lenders may reduce the loan amount and/or require the 1031 buyers to put all the sale proceeds into the substitute character.
A Successful Exchange
Your offer of $2.6M for the shopping center is accepted. The bank lends you $1.82M (70% LTV) at 4.5% interest amortized over 25 years. After paying $10,116/month for the mortgage, you nevertheless have over $6,000 a month positive cash flow! This is a substantial increase from $500 per month before the 1031 exchange.