By Dan Nuwash - Guest Blogger
November 27th, 2018
If you, your clients or people you work with are real estate investors, there is a high likelihood that you’ve heard of a 1031 Exchange. If you have paid attention to the process, you have probably learned that 1031 Exchanges are easy, hassle-free and have very loose guidelines… Said no one ever.
So, what is a 1031 Exchange? Well, 1031 just referrers to the IRS code that allows the tax advantageous strategy. When you sell an investment property and you have a profit, you normally are required to pay capital gains tax. A 1031 Exchange allows you to sell your real estate property and reinvest the proceeds in a “like-kind” investment, which defers any capital gains taxes. You also defer the 3.8% net investment income tax and the 25% depreciation recapture tax. We aren’t eliminating any of these taxes, we are just deferring them or “kicking the can down the road.”
See the below example:
I do need to point out that the under the Tax Cuts and Jobs Act the type of assets that qualify for a 1031 Exchange have become more limited. You can no longer do a 1031 Exchange on machinery, equipment, vehicles, artwork, collectibles, patents and other intellectual property and intangible business assets. If you or your clients happen to hold any of these assets, then stay tuned for our next article/newsletter over charitable LLC's which can be a great tax vehicle for those assets.
What are the rules, timing and qualifying variables for a 1031 exchange? The entire 1031 Exchange process must be completed within 180 days. The clock starts on the day the first investment property (relinquished property) is sold and the funds are escrowed with Qualified Intermediary (QI). It is essential that the seller never holds the proceeds from the sale outside of a QI. If you hold the funds at anytime during the process you eliminate your eligibility for a 1031 exchange and Uncle Sam will be collecting a check from you. I cannot stress the importance of working with an experienced QI and an experience real estate attorney to avoid this common mistake.
After the first investment property is sold, you have 45 days to notify your QI of potential replacement properties. To avoid any tax liability, you must identify a property(s) that are of equal or greater value than the relinquished property. You can identify up to 3 separate properties with no regard to their value (3 property rule), or you can identify an unlimited amount of properties that do not exceed more than 200% of the value of the relinquished property (200% rule).
Once you identify a replacement property(s), you must close on the sale of that property within 180 days of the relinquished property’s sale.
The non-timing related requirements to avoid a tax liability are: you must purchase a property of equal or greater value, reinvest all equity and maintain an equal or greater amount of debt. So, if you are selling a property that is worth $1,000,000 and you have a mortgage or loan on it for $500,000, then you must purchase a property for at least $1,000,000 and have a mortgage or loan on it of at least $500,000.
To reiterate the rules and timing at a high level:
To add some convenience to a 1031 exchange, you can incorporate a Delaware Statutory Trust (DST). A properly structured DST is recognized by the IRS as a qualified replacement property for real property. Therefore you need to use an experienced and reputable company that offers this vehicle, such as Cantor Fitzgerald.
Investors in a DST are not direct owners of the real estate; the property(s) title(s) are held by a trust. There are some great benefits to utilizing a DST, but also some restrictions. What I view as the greatest benefit is the flexibility a DST can add to a 1031 Exchange.
Some of the benefits:
One of the many ways a DST can add some flexibility to your 1031 Exchange is by making you a cash buyer after you relinquish your investment property. You must maintain equal amounts of debt and equity, and we can use a highly leveraged DST to satisfy the debt. For example, if your relinquished property was sold for $1,000,000 and you had $200,000 in debt, we could take $50,000 and put it in a DST that is 80% leveraged to satisfy the debt, which would give you $750,000 in remaining equity to purchase an investment property. If you’ve ever purchased a property, you know that cash is king. In addition, acquiring a loan to satisfy the debt could be difficult and time consuming, and failing to do so makes you ineligible for a 1031 Exchange.
See the below graphic for reference:
A DST could also satisfy any excess equity, or what is referred to as “the boot.” If you relinquished your property for $1,000,000 but in the 180 days you can only find another property that you purchase at $800,000, you could put the remaining $200,000 into a DST to defer any of the taxes.
The other great benefits a DST can add is negotiating leverage and a contingency plan. Real estate deals fall apart all the time, and if that deal happens to be a replacement property in a 1031 Exchange, you are in a bind. Using a DST as an “identified” property could be backup/contingency plan if the deal does fall through.
By creating a contingency plan, you have also removed leverage from any of the sellers you are working with. If the seller of one of your replacement properties knows or finds out you’re doing a 1031 Exchange, they have some leverage on you. They know you’re doing a 1031 Exchange to avoid a tax liability, and if you’re getting close to day 180, they might decide they don’t want to sell that replacement property for $1 million; they now want to sell if for $1.1 million.
There are some caveats to a DST, the primary one being a lack of liquidity. DST's are passive and very hands-off investments. You’ve removed the headaches of managing a property and you’re now invested into a professionally managed property(s), but you don’t get to decide when that property(s) you invested in is sold, and you cannot liquidate your position in a DST before the property(s) are sold.
The big takeaways from this article:
As always, if you have any questions, or would like to inquire about 1031 Exchanges or DST's, you can reach me directly at my contact information below.
Co-Founder, Finance For Thought