How to Maximize Cash Flow with a Tax 1031 – Deferred Exchange

A possible scenario for the 1031 exchange.

Let’s say you bought a residential property in the San Francisco Bay Area for $250K twenty years ago. Since the property is located in a good area, its value has appreciated to $1M. Over the years, he refinanced the original loan to consolidate his other debts and currently has a $300,000 mortgage on the property. Every month, he collects $3,000 in rent. After paying $1,800/month for the loan, $400/month for property taxes, and $60/month for insurance, you get $500 net cash flow/month after paying for property management and maintenance expenses.

As you get older, you realize that you need a reliable second source of income so you are not completely dependent on your salary. You’re also not satisfied with just $500 of cash flow a month on top of the $750K equity in your rental investment. So, when you see an attractive multi-tenant strip mall in a middle-class suburb of Dallas, lease 100% of NNN with $195,000/yr of net operating income (income after all expenses, excluding rent payment). mortgage) on the market for $2.6 million offering 7.5% cap, get excited!

Since the residential real estate market in the Bay Area has been very seller friendly, consider selling your rental property to buy this commercial strip. He estimates that he would have to pay about $250,000 in federal and state income taxes on $800,000 of capital gains ($1 million minus $250,000 in purchase price and sales fees, plus $50,000 in depreciation recovery). He just hates having to pay $250K to the government, money that can go towards his down payment on the commercial strip. There is a better way – a way to defer income tax.

What is a 1031 Tax Deferred Exchange?

Internal Revenue Code section 1031 generally provides that neither gain nor loss is recognized if the qualifying property is exchanged for another qualifying property of the same class. In the scenario above, you can defer paying $250K in federal and state taxes if you purchase another investment property with equal or greater debt and equal or greater equity. In other words, if you buy another investment property for $1 million or more, using all of the net proceeds as a down payment, then you can defer the $250,000 of taxes. Essentially, the government would loan you $250K, interest free. And you can repeat this deferral and never pay income taxes.

How do you qualify for a 1031 exchange?

You must adhere to several strict rules. Failure to follow any of the rules will disqualify your transaction from a tax-deferred 1031 exchange.

1. You must change. The property you buy (replacement property) must have equal or greater debt AND equity equal to or greater than the property you sell (transfer property). This means that you must put all of the net proceeds from the relinquished property toward the replacement property. The FMV of the replacement property must also be greater than the FMV of the relinquished property.
2. The qualifying property must be of the same type. The transferred and replaced property must be held for productive use in a trade or business or for investment, before and after the exchange. And a property class cannot be exchanged for another property class. For example, you cannot exchange a residential rental property for one you intend to occupy as your primary residence, which does not qualify as property. And you can’t trade a factory for equipment, not like the guy. On the other hand, residential and commercial real estate are of the same class. So, you can trade a residential rental property for a shopping center.
3. In a delayed exchange, you must identify the replacement property within 45 days and receive it within 180 days from the closing date of the relinquished property or before your tax return due date (with extension). , The thing that happens first.
4. You can identify up to 3 replacement properties and you must close the escrow with at least 1 of the 3. Alternatively, you can identify as many properties as you like, as long as the total value of these properties does not exceed 200% of the property’s value. relinquished property.
5. You must acquire the property for investment purposes and not primarily to resell it for a profit. While the IRS does not say how long you have the property before you can qualify for the 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 withstand an IRS audit.
6. You must have an exchange broker hold the proceeds from the sale of the relinquished property. Most investors use an exchange company as a qualified intermediary for a delayed 1031 exchange.
7. If you exchange a property with a related person (your children, parents), both parties cannot dispose of the property within 2 years.
8. If the proceeds of the sale are deposited into an interest-bearing account during the exchange, you must receive the interest AFTER the closing of the replacement property escrow.

What expenses are allowed?

You can use the 1031 proceeds to pay certain costs of selling the relinquished property and costs of buying the replacement property: homeowner’s title insurance premiums, escrow agent or closing attorney fees, real estate broker commissions estate, 1031 exchange broker fees, document transfer taxes, filing fees, and tax advisor fees. You cannot use the 1031 procedure to pay these expenses: loan fees/points, appraisal fees, mortgage insurance premiums, lender’s title insurance policy premiums, homeowners insurance premium, repair and/or maintenance costs.

Strategies for a Successful 1031 Exchange

The following strategies are intended for investors seeking commercial property as a replacement property.

1. Have 3 plans for your 1031 exchange: A, B, and C, with plan A being the best case and plan C being the worst. Have at least one different property for each plan.
2. Start looking for a replacement property early. Since you only have 45 days to identify replacement properties, you should make an offer as soon as the relinquished property is in escrow. By the time you close on escrow on the relinquished property, you should have an accepted offer on a replacement property. This first property does not have to be the most desirable property at the best price. Mentally, you need to think of it as a worst-case plan C property. That way, you don’t wait until the last few minutes to make an offer. It’s also meant to take away worries so you sleep well, like “Oh my gosh, what if I can’t find a replacement property?”
3. Identify more than 1 replacement property. If something unexpected comes up with your first pick, say the soil is contaminated, you have plan B and plan C properties to fall back on.
4. Specify a 30-day due diligence and cancellation period in the contract. This will give you more time to specify more than 1 property.
5. Think twice before choosing a loan assumption replacement property. It is much more difficult to get lender approval for a loan assumption than it is for a new loan. Also, you only have one chance to get approved for a loan assumption versus many chances to get approved for a new loan. You do not want the lender to decline to assume your loan after the 45-day identification period.

Questions for a 1031 Exchange Broker

Technically, you don’t need a 1031 exchange company to handle the exchange. However, it is recommended that an expert help you. This company will make sure that you abide by the strict rules of the IRS. To decide which company to serve you, you should consider:

1. The fee is around $500-$750 per transaction. The company that charges less tends to limit you to 3 replacement properties and the company that charges more may not have that limit.
2. Whether your earnings will be deposited into 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 bankrupt, as some of them did during the recession, it is easier to show that the money in the separate trust account is your money and not the exchange company’s money.
3. Whether your earnings will earn interest and whether the money is insured.

What if you want to buy the replacement property first?

For some investors, the strict 45-day identification period and 180-day exchange period may be too short. Also, some investors would only consider doing a 1031 exchange only if they want to find suitable replacement properties. The alternative is to consider a reverse exchange in which the replacement property is purchased first before the relinquished property is sold. However, the replacement property must be owned by an intermediary party during the pendency of the exchange of the same type until the taxpayer can sell the relinquished property. The replacement property is then exchanged to the taxpayer. A reverse delayed trade is an advanced strategy with a different set of challenging issues that are not intended for average investors. You should consult a tax advisor for guidance.

What are some of the possible problems?

Due to time limits on the 1031 exchange, some people may want to take advantage of their situation. Therefore, you need to mentally realize and accept the fact that as a 1031 buyer, you may not be in the best position to negotiate.

1. There are sellers or listing brokers who feel very positive about 1031 buyers. They reason that these buyers will either have to buy out and close the trust or send a big check to Uncle Sam. On the other hand, some sellers or listing brokers feel negative about 1031 buyers. They reason that 1031 buyers will offer to buy 3 properties and close the trust on one. And so there’s a 33% chance that 1031 buyers will close on escrow. And so these sellers may not be receptive to your offers.
2. Sellers know 1031 buyers have to close escrow. And therefore they may become less flexible in negotiating with 1031 buyers once the purchase contract is executed. For example, you request a repair credit that they may accept in a normal transaction, but may be denied in a 1031 transaction. So it’s important to have back-up property, just in case.
3. Some lenders may reduce the loan amount and/or require 1031 buyers to put all of the proceeds of the sale into the replacement property.

a successful exchange

His offer of $2.6 million for the mall is accepted. The bank lends you $1.82M (70% LTV) at 4.5% interest amortized over 25 years. After paying $10,116/mo on the mortgage, you still have a positive cash flow of over $6,000 a month! This is a substantial increase from $500 per month before the 1031 exchange.