The Secret Tax Advantage Used By The Best Real Estate Investors. What is a 1031 Exchange? | Nexus Property Management® Franchise
Learn The Ins And Outs Of Using A 1031 Exchange For Real Estate Transactions.
A 1031 exchange is one of the best financial saving tools available to investors. What it does, in simple terms, is give you the ability to sell an investment property and invest the gain (profit) into a like kind property (or properties). For example, if you own a multi-family property, you are able to sell that and buy another investment style property. You wouldn’t be able to exchange and buy a single family property for your primary residence, or even something such as a piece of art. The exchange has to be like kind in nature. Here’s a good website to help you determine if you qualify to perform this type of transaction.
What we will do now is go over an example one of our investors recently experienced. This will help you understand how the process works and when it makes sense to do this type of transaction.
Example Of A 1031 Exchange Situation With A Nexus™ Nvest® Client
Investor John bought a multi-family property in Rhode Island at the end of 2016 for $100,000. This property was in severe disrepair, and underwent $100,000 worth of renovations over the course of 2017. After the work was completed all of the apartments were rented, and John ended up refinancing the property with his newfound equity. He obtained a loan for $360,000 based on the appraised value of $530,000. At this point, John withdrew just about $200,000 in tax free cash and was able to purchase more properties. The problem now is that since the mortgage is a higher amount, and operating expenses (utilities, taxes, insurance, etc) are rising, the cash flow has become depleted severely. So, instead of treading water for 25 years until the mortgage is paid off John chose to sell the property and perform a 1031 exchange.
The property was listed at $640,000 and ultimately sold for $600,000. So, let’s calculate how John’s transaction panned out. First and foremost, John owed the bank their $360,000 back. So, that comes right from the proceeds leaving $240,000. Then, the realtor commission of $20,000 was deducted, and then another $10,000 for closing costs. This leaves approximately $210,000 of proceeds (aka cash) available to exchange and re-invest.
The proceeds are different from the actual gain however. The way the IRS calculates your taxable gain is by determining your initial cost basis. That is what you paid for it, what you put into it (repairs), and what you paid in commission to sell it. So, in John’s case the initial cost basis is $100,000 (purchase price), $100,000 (repairs), and $20,000 (commission). The total cost basis is $220,000. You then subtract this from $600,000 and you get $380,000 in taxable gain. The $380,000 is what the IRS would tax you on if you didn’t perform the 1031 exchange. At today’s tax rates that would probably be about $90,000 owed! Crazy!
So, in order to avoid the capital gains tax of $90,000 John has to purchase property (or properties) that are like kind and their purchase price exceeds $380,000. Make sense? So, if John buys 2 properties for $200,000 he has spent $400,000 on paper. This would satisfy the 1031 exchange requirement. Keep in mind that once John buys the properties his depreciation will be adjusted. So, he bought $400,000 worth of properties, but had a gain of $380,000, so only $20,000 is available to depreciate over time ($10,000 per property). Depreciation is valuable to you as an investor, but obviously its more important to sacrifice that than pay $90,000 up front. Make sense?
How To Calculate Gain On Property Sale.
A couple important items to note…First, even though John refinanced (and ultimately reduced his available cash proceeds) it does not effect the calculation of the gain. There is a misconception out there that you calculate your gain based on paying your mortgage off. This is not true. Your gain is calculated by determining your purchase price (originally), repairs, commission, and ultimately the sale price. Other expenses are unrelated. It is structured this way because you would be able to perform a cash out refinance for the maximum available right before the sale of the property, thus skipping the majority of taxes. The IRS does not allow this.
Second, you have to assign a designated intermediary to handle the transaction for you. This is a 3rd party agency that will hold the proceeds of the sale and disperse them as you buy your like kind properties. The IRS requires that you locate these properties within 45 days, and then close on them within 180 days. If you miss either of these deadlines the intermediary must release the cash funds to you and then you will be subject to capital gains.
1031 exchanges can be very cumbersome and confusing if it’s your first time, so make sure you ask your CPA, your attorney, and your realtor about it. Each person will be able to give you some information that can help you understand it better. Also, don’t forget to pick a qualified (and trusted) intermediary before you sell your property. It’s best to have the intermediary lined up before the sale happens so that way you don’t waste precious time!
To learn more about the intricacies of the 1031 exchange check out this website:
We would love to hear your feedback on this topic, and also, talk about your experience with the 1031 exchange! Post a comment below so we can start a discussion!
Gregory Rice is the Vice President of franchise sales for Nexus Property Management®.
Nexus Property Management® is a National Property Management Franchise that manages all types of rental property from single family homes or condos to large apartment buildings and complexes.
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