WHY USE GLOBAL REALTY GROUP COMMERCIAL FOR YOUR EXCHANGE
Our agents and brokers:
- Have access to a large database of out of state commercial replacement properties with favorable returns
- Have the skill, experience, and expertise to help avoid a failed exchange
- Have a top-notch team of experienced professionals including the best exchange accommodators
WHAT IS A 1031 EXCHANGE
1031 Exchange – Key to Wealth Building in Real Estate. The Internal Revenue Service under code section 1031 defines a property that qualifies for an exchange as any real property held for productive use in trade or business. The code specifies the phase ‘like kind’ which is often confused by investors as meaning replacing an investment with the exact property or product type as the property the owner is selling.
An investment property is taxed on any amount in excess of the basis. The basis is the difference between the current final net sales price (minus depreciation plus improvement) and the original value at the time of purchase. The difference would be subject to capital gains. A property bought ten years ago for $500.000.00 that is now worth and sold for a net of $1 million would be subject to a $500,000.00 gain minus the expenses of the sales. If the property is sold for more than the basis, it is considered a gain taxable by the IRS.
REASON FOR THE EXCHANGE – AVOID CAPITAL GAINS
There will be state, federal and depreciation recapture taxes the government will go after if you sell a property with out an exchange. The amount of taxes an investor will pay is about 33% of the gain. About 20% in federal taxes which include Medicare and depreciation recapture will be assessed(note: depreciation recapture will be taxed at 25%). There will also be 9.3% or more in California state taxes. All in total an investor would pay about a third of the gain in taxes which can add up to thousands, even tens of thousands of dollars in some cases.
What makes 1031 exchanges the most effective way to building and maintain generational wealth is taxes are deferred until which time the investor fails to utilize an exchange. There is an acronym (DUD) which stands for Defer Until Death. Taxes can be deferred as many times throughout the lifetime of an investor as they wish. When the investor passes away, the gain for all exchanges dies with them and the heirs get a stepped-up basis as of the date of death (they can sell the properties the day after the decedents passing and pay no taxes!!!)
WHAT QUALIFIES AS AN EXCHANGE – PROPERTY UP FOR SALE
An income producing asset must be used for business purposes meaning the owner has seasoned rents collected for one year or more. Although the code does not specify this, it would be prudent to have two or more years to limit the risk of an audit.
There is no limit to how many properties can be exchanged; however, the full proceeds from the sale must be used as a deposit, a portion of purchase price or the full price of the ‘up-leg’ property. The sales price of the relinquished investment(s) must be less than the amount of the replacement property to avoid capital gains.
A property sold for $1,000,000.00 where the investor purchases a property for $950,000.00 would be subject to capital gains taxes for the difference as this is considered a ‘boot’. An investor can purchase as many replacement properties as they like but the total amount of the sale is at or exceeds the sale price of the relinquished property. For the purposes of not being subject to capital gains, the sales price of the replacement property cannot exceed the amount of the final sales price of the relinquished property.
QUALIFICATIONS FOR THE IDENTIFYING AN UPLEG OR REPLACEMENT PROPERTY
The code requires that the investor provide written identification letter specifying replacement properties they plan to purchase. There as two ways to meet the requirement. One is the ‘three-property’ rule where a maximum of the three properties must be identified in writing no later than 45 days after the close of escrow on the relinquished property. One of the three properties must be purchased as the replacement, or the investor is subject to capital gains.
The other way to meet the requirement is something called the 200% rule. An investor can identify as many properties as they want; however, the sum of all the properties cannot equate to no more than 200% of the amount of the relinquished property.
WHAT YOU CAN DO
- An investor is allowed to exchange an income producing property for another income producing property anywhere in the US.
- Replace a single-family home rental in California for a commercial retail property in Nevada or a 10-unit multifamily residential property for an office building in Nebraska
- Use Section 121 and 1031 together to obtain the $250, 000.00-$500,000.00 tax exemption as well as the tax deferral. These are usually done with 2-4 units, mixed use, and similar type of properties where the investor lives on site. They can use the exemption allowed under IRS Section 121 and then use Section 1031 to do an exchange on the value of the property rented out.
- Do an exchange on an Airbnb property, a vacation rental or second home if the property was personally used by the owner no more than 14 days out of a twelve-month calendar year or 10% of the amount of days in the year the property was rented (the greater of the two options)
- Do a partial exchange by receiving cash or trading down
WHAT YOU CANNOT DO
- An investor is not allowed to exchange a property in the US for a property outside of the US
- An investor is not allowed to exchange a property considered as ‘inventory’ (meaning the property must be held as an income producing asset) Flipped properties do not qualify as an exchange.
- Purchase a REIT or stock in a real estate corporation
- Exceed personal use limitation rules for vacation or second homes(example: Owner who rented out vacation home for 300 days out of the unit can not personally use the property for more than 31 days out of the year because it exceeds 10% of days it was rented.)
- Get an extension on the time limitation of an exchange (exception is Presidential Disaster Declaration).
- Trade down on the replacement property or use some of the sale to pay off items unrelated to the cost of the transaction without being assessed capital gains taxes.
BENEFITS OF 1031 EXCHANGES
Reset Depreciation Schedule: A huge benefit for owning rental property is the deduction for depreciation which is calculated as the value of the property multiplied by 85%(factor) divided by 27.5. The depreciation deduction amount usually starts to decline between year seven and year nine. So, not only can an investor sell a property with declining depreciation but can acquire a larger property to reset the depreciation schedule while sheltering more rental income from taxes.
Produce Greater Returns: In high equity markets like California, investors who effectively leverage can realize greater returns. An investor who exchanges a property owned free and clear and uses the proceeds as a down payment (or new equity on the replacement)can double the return on the replacement property .
Investing Horizontally for Diversification: An investor either invest vertically (purchase a portfolio of properties in one specific area or horizontally (portfolio is scattered throughout multiple states). The benefit of horizontal investing is reducing the volatility of the asset portfolio while decreasing risk. If a major earthquake hits the Los Angeles area and shuts all commerce down indefinitely, what would this do to your ROI/cashflow? Geographical diversification is one of the most viable options for prudent investors.
Many investors have had their fill of the day-to-day burden of handling the operation of the properties. That is why exchanging into a Triple Net Lease property or a DST (Delaware Statutory Trust) is attracting more investor each day.
Click here for our webpage on out of state Triple Net Lease Commercial Properties for sale.
Give us a call for a free consultation!