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 foundation to borrow 3x that amount, ending up with an property you bought with other peoples money, 75% loan from bank, and the IRS 25% that could have been sent away for capital gain tax.
Pretend it is 50k that you don’t have to send to IRS because of 1031. You buy 2 replacement properties with all your sale proceeds instead of buying just one property. You use 200k, of your 250k capital gains tax as a down payment and get a 75% loan for 600k and buy one property for 800k. Take the remaining 50k, that represents the money you were going to pay the IRS and use that as your 25% down payment to get a loan for 150k and you have a total of 200k to buy another property. Your free money is now multiplied by 4. It is now 200k. This 200k, you would not otherwise had access to if you didn’t defer the capital gain tax from the profit of the sale. Because the 50k you used as down payment to qualify for the loan would have gone to the IRS, it would be gone forever.
If you keep the investment of the 50k for 10 years in an investment property it can grow. Pretend the initial 200k grew and you sold the property. With the sales proceed, cost associated and your 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 now become 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 to make the sale,
Pretend this investment cash flows and pays all your expenses, including property tax and principal and interest and provide capital for 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 of Sale is 5%. Tax rate is 30%. Reinvest all proceeds from property sales and buy twice as much property as proceeds after each sale.
Keep in mind what happens when you sell and are hit with capital gains tax. It will take 15-40% of your gain when you sell! 1031 exchange allows you to defer taxes when you sell and buy another. You can invest the entire amount you earn. You don’t have to worry about getting rid of your investment and pay Uncle Sam a large portion of your equity. When doing a 1031, you must buy as 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 the process IRS for you to go through a Qualified Intermediary (QI). They hold your sales proceeds in escrow, and advise you on the rules. 1031 is for like kind. It really is anything that is held for investment purposes only. When you 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 down payment on a bigger property that will bring you higher cashflow than what you once had with the previous property. With the equity that is from the sale, you can’t touch it all or it will be taxed. The money will be in a 3rd party escrow, until you make a decision and give authorization in writing to move into a replacement property. You have 45 days to identify the properties you would like to buy. It is wise to start the search before you sale the existing property.
When selling and doing a 1031, you can take out money, but you will get taxed on that money (this is called “the boot”). So if you sell your apartment and want to take out 100k, to remodel your personal residence, you can but you will be only taxed on the 100k, while the rest goes to another property.
Qualified Intermediary known as the QI. They never enter the chain of title and becomes an agent for the Exchangor. A QI is needed because they can vever have actual or constructive recipept 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 Compay 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 an 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 Exhangor 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 Exhangor 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 time period in which the Exchangor must identify the potential properties one or more of which they will purchase as a replacement property. The time starts on the exchange date. The is the date on which the Exchangor transfers the relinquished property to the buyer. A transfer occurs on the earlier of the date the exchanger signs the document evidencing the transfer (usually a deed) or the date the document is filed in the public records. The date normally used is the date on the Title Company HUD -1 Settlement Statement, which will be usually be the date the transaction closed. During the 45 day period, the Exchangor must identify the possible properties that they will acquire as replacement property. They identify them to their QI, who documents the action for IRS purposes. He can identify 3 possible properties without regard to the Fair Market Value (FMV) of each one, and without regard to the total FMV of all three. Remember, what he buys must have a value equal to, or greater than, the Sales Price of what he is selling. Of they can identify more than 3 possible properties and state the FMV of each one, provided the combined FMV of all three is not more than 200% of the FMV of the relinquished property. In other words, they can sell an apartment building for 1 million. And identify 40 houses with an average of FMV of 50k each, totaling 2 million. Not that anyone would but this just shows how it works.
The replacement property should be identified with sufficient detail to distinguish it from any other piece of property. The legal description is the best choice.
In addition to identifying the property, it is also required to identify the tangible personal property that will complete the exchange. After the Exchangor creates the list and provides it to the QI, they can make changes to it during the 45 day period but it is set on the last day and cant be changed after that. All this would be documented with signatures and dates. Example, 12-31-2018, that means that day 1 is Jan 1 and day 30 is Jan 30 and Day 45 is Feb 14. So the exchanger must present the list to the QI on or before the 12am on Feb 14. Good way is to allow yourself 30 days to identify these possible properties and then you have another 15 days to deal with any unforeseen problems and make changes.
Time line 180 days…this run just like the 45 day period. This time period is the time period in which the Exchangor must acquire the replacement property. If the exchange date is on one tax year like Dec 21 and the 180 day period extends into the following year which it would beyond the day that the entity tax return is due, April 15th, the period terminates on the date of the tax return which in this example would be 115 days after Dec 21 instead of 180 days, unless the due date of the tax return is extended. So the rule is either 180 days or the due date including extensions of the tax return covering the period in which any part of the transaction occurred which ever comes first. Our exchange date is Dec 31, and the 180 day period expires on June 29. But there is a tax return due during that period and this would terminate the running of the time period. So the rule is either 180 days or the due date including extension of the tax return covering the period in which any part of the transaction occurred whichever comes first. Our exchange date is Dec 31 and the 180 day period expires on June 29, but there is a tax return due during that period, and this would terminate the running of the time period. So it will be necessary for us to get an extension for the tax return due in March or April that is before the expiration of the 180 day period and we would lose that final two months if we do not get the extensions.
To be completely tax deferred, all the proceeds from the sale must be used to buy the replacement property. The Exchangor can’t get any of the money, if they 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 purchase the next property be equal to the debt paid off on the sold property, or the difference 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 that was paid off or add your own money.
IRS can care less where you get the money, or what debts are paid from the sale. When you use all your net sales proceeds to buy a property equal or greater in value, you will have to get a new loan to at least equal to the other or use your own money.
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.