1031 Exchange - Small Apartment Investors

Deferring capital gains tax through 1031 Exchange, allows you to pay it when you are ready and you may never have to pay it!

Think about it, you can use the IRS money as the foundationto borrow 3x that amount, ending up with an property you bought with otherpeoples money, 75% loan from bank, and the IRS 25% that could have been sentaway for capital gain tax.

Pretend it is 50k that you don’t have to send to IRS becauseof 1031. You buy 2 replacementproperties with all your sale proceeds instead of buying just one property. Youuse 200k, of your 250k capital gains tax as a down payment and get a 75% loanfor 600k and buy one property for 800k. Take the remaining 50k, that represents the money you were going to paythe IRS and use that as your 25% down payment to get a loan for 150k and youhave a total of 200k to buy another property. Your free money is now multiplied by 4. It is now 200k. This 200k, youwould not otherwise had access to if you didn’t defer the capital gain tax fromthe profit of the sale. Because the 50kyou used as down payment to qualify for the loan would have gone to the IRS, itwould be gone forever.

If you keep the investment of the 50k for 10 years in aninvestment property it can grow. Pretendthe initial 200k grew and you sold the property. With the sales proceed, cost associated andyour equity, you now have $238,170 (around 25%) to use as a down payment. You qualify for a $713,510 loan (around 75%)and you would be able to purchase a new property in the range of 950k. The 50k, you held back from the IRS has nowbecome 950k worth on investment property an increase of 19x in 10 years. Remember this was not your money anyway.

The sales proceed is $358,170. Your equity is $180,186. and after all costs to sell associated tomake the sale,

Pretend this investment cash flows and pays all yourexpenses, including property tax and principal and interest and provide capitalfor expenditures.

Sell and buy new property every 5 years	Perform 1031 exchange	Don’t perform 1031
Year 1 sell apartment	$1,400,000	$1,002,500
Year 5 proceeds from sale	$1,683,669	$1,144,689
Year 10 proceeds from sale	$2,024,815	$1,307,046
Year 15 proceeds from sale	$2,435,085	$1,492,430
Year 20 proceeds from sale	$2,928,484	$1,704,108

Assumptions: Apartment is free and clear when selling.

50% LTV on each purchase. Appreciation rate is 3%. Cost ofSale is 5%. Tax rate is 30%. Reinvest all proceeds from property sales andbuy twice as much property as proceeds after each sale.

Keep in mind what happens when you sell and are hit withcapital gains tax. It will take 15-40%of your gain when you sell! 1031exchange allows you to defer taxes when you sell and buy another. You can invest the entire amount youearn. You don’t have to worry aboutgetting rid of your investment and pay Uncle Sam a large portion of yourequity. When doing a 1031, you must buyas much as you sold and reinvest the proceeds. It must be equal or more in value.

Complex rules: 3 property rule, the 200% rule and 95%rule. To help navigate through theprocess IRS for you to go through a Qualified Intermediary (QI). They hold your sales proceeds in escrow, andadvise you on the rules. 1031 is forlike kind. It really is anything that isheld for investment purposes only. Whenyou do a 1031 no amount is carved out that goes to taxes. It is all reinvested into another property.

The equity you have when you sell, can be used as a downpayment on a bigger property that will bring you higher cashflow than what youonce had with the previous property. With the equity that is from the sale, you can’t touch it all or it willbe taxed. The money will be in a 3^rdparty escrow, until you make a decision and give authorization in writing tomove into a replacement property. Youhave 45 days to identify the properties you would like to buy. It is wise to start the search before yousale the existing property.

When selling and doing a 1031, you can take out money, butyou will get taxed on that money (this is called “the boot”). So if you sell your apartment and want totake out 100k, to remodel your personal residence, you can but you will be onlytaxed on the 100k, while the rest goes to another property.

Qualified Intermediary known as the QI. They never enter the chain of title and become an agent for the Exchangor. A QI is needed because they can never have actual or constructive receipt of the funds from the sale of the relinquished property in order to qualify to do a section 1031 exchange. Constructive receipt occurs when the Exchangor is able to control, direct or exert influence over the entity which actually receives the funds. The QI is supposed to be an independent entity which receives the Exhangor’s funds from the sale of the relinquish property from the Title Company at closing, holds the funds and then transfers them back to the Title Company to do the closing on the Exchangor’s purchase of the Replacement Property. The Exchangor never receives or has control of the funds. The QI is paid by the Exchangor for this service.

With 1031, the taxpayer is not allowed to receive or have control over the Net Sales Proceeds from the sale of the relinquished property. You need a QI to handle the funds from the first sale.

The QI will:

Answer the Exchangor’s questions about the 1031 process, but not give advice.
Draft an “Exchange Agreement” between the Exchangor and the QI outlining exactly what will take place and each party’s rights and responsibilities.
Review the Sales Contract concerning the Relinquished Property to make sure that the Exchangors information is correct.
Review the deed which originally put the relinquished property into the Exchangor’s name to make sure that it is the same as the name on the sales contract, and the property has been held for the required period of time.
Provide the Exchangor with an addendum to be added to the contract regarding the sale of the relinquished property to be signed by the buyer, acknowledging that the transaction is part of a 1031 and promising to cooperate, while being assured that there will be no additional cost or liability in doing so.
Draft an “assignment of benefits” from the Exchangor to the QI of the Exchangor’s contract to sell the relinquished property.
Draft and send notices of the Assignment to all other parties to the contract, such as the real estate agent, the Title Company and any financing entities.
Open a bank account in the name of the Exchangor and with the Exchangor’s social security number or federal tax identification number usually a Qualified Escrow Account, but preferably a Qualified Trust Account. If the Exchangor will be providing more than the 250k amount that is the max insured by the FDIC, then multiple accounts will be opened.
Review the Title Insurance Commitment to ensure that the information is correct.
Review and approve the Title Company’s proposed HUD-1 Settlement Statement for accuracy.
Review the proposed deed for Relinquished Property for accuracy.
Upon closing, receive the Net Sales Proceeds from the Title Company and deposit them into the Exchangor’s account or accounts.
Provide a form on which the Exchanger will identify the potential Replacement Properties within 45 days after closing on the Relinquished Property and verify that it is correct.
When a contract is signed on one of the replacement properties, repeal all the steps above.
Monitor the 180-day time period for closing on the replacement property.
When the closing is scheduled on the replacement property, transfer the Exchangor’s funds to the Title Company to be used for purchasing the property.
Provide the Exchange an accounting of the entire transaction.
Provide the Exchangor copies of all appropriate documents.

The first time period involved in a 1031 is the 45 day timeperiod in which the Exchangor must identify the potential properties one ormore of which they will purchase as a replacement property. The time starts on the exchange date. The is the date on which the Exchangortransfers the relinquished property to the buyer. A transfer occurs on the earlier of the datethe exchanger signs the document evidencing the transfer (usually a deed) orthe date the document is filed in the public records. The date normally used is the date on theTitle Company HUD -1 Settlement Statement, which will be usually be the datethe transaction closed. During the 45day period, the Exchangor must identify the possible properties that they willacquire as replacement property. They identifythem to their QI, who documents the action for IRS purposes. He can identify 3 possible properties withoutregard to the Fair Market Value (FMV) of each one, and without regard to thetotal FMV of all three. Remember, whathe buys must have a value equal to, or greater than, the Sales Price of what heis selling. Of they can identify morethan 3 possible properties and state the FMV of each one, provided the combinedFMV of all three is not more than 200% of the FMV of the relinquishedproperty. In other words, they can sellan apartment building for 1 million. Andidentify 40 houses with an average of FMV of 50k each, totaling 2 million. Not that anyone would but this just shows howit works.

The replacement property should be identified withsufficient detail to distinguish it from any other piece of property. The legal description is the bestchoice.

In addition to identifying the property, it is also requiredto identify the tangible personal property that will complete theexchange. After the Exchangor createsthe list and provides it to the QI, they can make changes to it during the 45day period but it is set on the last day and cant be changed after that. Allthis would be documented with signatures and dates. Example, 12-31-2018, that means that day 1 isJan 1 and day 30 is Jan 30 and Day 45 is Feb 14. So the exchanger must present the list to theQI on or before the 12am on Feb 14. Goodway is to allow yourself 30 days to identify these possible properties and thenyou have another 15 days to deal with any unforeseen problems and makechanges.

Time line 180 days…this run just like the 45 dayperiod. This time period is the timeperiod in which the Exchangor must acquire the replacement property. If the exchange date is on one tax year likeDec 21 and the 180 day period extends into the following year which it wouldbeyond the day that the entity tax return is due, April 15^th, theperiod terminates on the date of the tax return which in this example would be115 days after Dec 21 instead of 180 days, unless the due date of the taxreturn is extended. So the rule iseither 180 days or the due date including extensions of the tax return coveringthe period in which any part of the transaction occurred which ever comesfirst. Our exchange date is Dec 31, andthe 180 day period expires on June 29. But there is a tax return due during that period and this wouldterminate the running of the time period. So the rule is either 180 days or the due date including extension ofthe tax return covering the period in which any part of the transaction occurredwhichever comes first. Our exchange dateis Dec 31 and the 180 day period expires on June 29, but there is a tax returndue during that period, and this would terminate the running of the timeperiod. So it will be necessary for usto get an extension for the tax return due in March or April that is before theexpiration of the 180 day period and we would lose that final two months if wedo not get the extensions.

To be completely tax deferred, all the proceeds from thesale must be used to buy the replacement property. The Exchangor can’t get any of the money, ifthey do they will be taxed. Remember,the replacement property to be purchased next, needs to be as an investment,must be equal or greater than the sold property.

It is not required to have the money you borrow to purchasethe next property be equal to the debt paid off on the sold property, or thedifference must be made up by adding cash.

For example, sell your investment property for 1 million. Pay off the loan of 900k. You get 100k in cash. This 100k must be reinvested in 1031. But you must buy a new property that is 1 million. So either:

Get a new loan for 900k to go with the 100k
Use the 900k of your own money
Some combo of new loan and personal cash

You have to either get new financing equal to the debt thatwas paid off or add your own money.

IRS can care less where you get the money, or what debts arepaid from the sale. When you use allyour net sales proceeds to buy a property equal or greater in value, you willhave to get a new loan to at least equal to the other or use your ownmoney.

There are depreciation considerations as well when a 1031 takes place. Talk to your accountant for instructions. You can’t do a 1031 with a second home or vacation property.