Friday, July 20, 2007

1031 Exchange? Yes Please!

Do you know the worst part about making money in commercial real estate???

Having to share it with the government when you decide to sell your investment property

Did you know there was a way to put off paying taxes on the money you earn on investment properties? And notice that I said put off and not avoid...unfortunately taxes are as sure as death so maybe you won't be paying the taxes today but you will have to pay eventually. I'll try and explain the process so even the most inexperienced investor understands the basics.

Something you really need to know about if you are planning on investing in real estate and what I am referring to is a 1031 exchange. The name comes from the particular section of the Internal Revenue Code (section 1031). Basically it's a way for you to sell a property and defer paying capital gains taxes by purchasing another property and reinvesting all of your profit.

As far as the person selling the property and completing the 1031 exchange is concerned, the whole process is transparent. You will have to add a few extra lines to the P&S but that's about it...

Here is how it works. I will use as an example, Steve, an investor, who currently owns a 3 family investment property and wants to buy a larger 6 family property.

  1. Steve first consults his accountant and his financial planner to figure out his tax situation and what kind of profit he is looking at with the sale of his 3 family. He bought the 3 family for $100,000 3 years ago and its now worth $300,000. He has a potential gain of $200,000. The 6 family he wants to buy is listed for $500,000.

  2. He contacts a QI (Qualified Intermediary) to discuss the 1031 exchange procedure. The QI is the middle man in the 1031 exchange process and you must use a QI, you can't do this on your own so don't try it.

  3. Steve finds a buyer for his 3 family and puts in an offer for the 6 family which is accepted. Naturally he used a Buyer's Agent to find the new property. Here is where the fun begins...hold on tight!!!

  4. Steve sells his 3 family and the $200K profit he just made is immediately transferred to the QI to hold for safe keeping until Steve closes on the 6 family.

  5. At the same time as Steve is selling his 3 family, he is also working on closing on the 6 family. The QI takes the $200K he is holding for Steve and gives it to the guy selling Steve the 6 family. Steve then closes on the 6 family and never even sees the $200K and therefore doesn't have to pay any taxes on it. It's a beautiful thing...

Now for those of you that have had experience with a 1031 exchange, you will notice that I left out some of the details but my point here is to explain the process in a way that a novice investor can understand it. There are a couple of good references at the bottom of the post if you would like to learn more about 1031 exchanges. Here are some important points to consider when deciding to do a 1031 exchange...

  1. The property you are buying must be of equal or greater value as the property you are selling.

  2. In order to defer all capital gains taxes, you must reinvest all of your profits from the property you are selling into the property you are buying.

  3. The IRS has a very strict timetable to complete a 1031 exchange. From the date that you sell your property you have 45 days to identify the property you wish to purchase and you must close on the new property within 180 days of the date that you sell the first property. The IRS doesn't care about weekends or holidays either...its calender days so if the 180th day is a Sunday and you waited until the last minute, you're out of luck since you can't record at the Registry of Deeds on a Sunday.

  4. You are not avoiding the tax on the gain. In the example above, the gain was $200K but the money was reinvested in the new property. At some point, if Steve sells the 6 family, he has to pay taxes on the $200K profit he made on the sale of the 3 family unless he does another 1031 exchange and buys a property of even greater value.

  5. You must hold the investment property for at least 2 years before the IRS will allow you to sell it and defer the payment of capital gains taxes.

Typically a QI will charge $1,500 to complete a 1031 exchange. I say typically because I only know about companies in my area and they all charge the same. Unfortunately there is no current regulations or licensing involved with being a QI so technically I guess they could charge whatever they want. If you are going down this road, make sure the company you are working with is reputable because as in my example above, the QI takes possession of $200K of Steve's money for a period of time while the exchange is completed. You have to be sure you can trust somebody holding $200K of your money.

Here are a couple of good resources to learn more about 1031 exchanges...

The Exchange Authority - This company is in Massachusetts but handles transactions all over the country and even overseas. I am working with a client completing a 1031 exchange now with this company. Tim Halligan is the man over there...

1031 Exchange, Wikipedia

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