Save Big (or not) With 1031 Exchanges

You’ve found a great asset.  You’ve done your due diligence.  It’s in the best market and sub market.  It has strong financials that are poised to give you just the kind of returns that will set you along the path to financial freedom.  You decide to go for it!

Fast forward 10 years.  Fantastic news!  That great asset you found way back when has done wonders for you over the last 10 years.  Not only has the property appreciated exactly the way you had predicted, but it has been spitting cash at you since you closed.  Now you have a grand new plan.  You have decided to aim at a bigger and better piece of commercial real estate.  The question becomes:  what is the best way to handle the sale of your current property and the purchase of your bigger and better property?

You vaguely remember someone telling you about something called a 1031 exchange.  You might even recall something about a reverse 1031 exchange.  Are any of these methods right for you?  In order to answer that question, we first have to define a 1031 exchange and then think about what the processes involved in a property exchange look like.

A 1031 Exchange Definition

A 1031 exchange (also called a ‘like-kind exchange’) is a tax treatment that allows a property owner to postpone taxes owed on any gains made through the sale of his or her property.  If so elected, the owner selling their property selects a like-kind property to purchase within a specified period of time and re-invests any proceeds from the sale of their first property.  This re-investment of proceeds is not taxed at the time of the transaction as would occur normally, but is instead deferred until that time that the owner purchases another property without the use of a 1031 exchange, or until that time that the holder chooses not to re-invest their gains.  A 1031 Exchange can be used serially and in perpetuity, effectively eliminating the tax burden on gains realized from certain real estate investments.

A Reverse 1031 Exchange Definition

Now that you have a firm understanding of the straight-forward 1031 exchange, let’s examine a ‘reverse’ 1031 exchange.  In the straight 1031 exchange scenario, the steps are fairly straight forward:  you sell your property, select a replacement ‘like-kind’ property (within that specified period of time) and purchase the replacement property.  Under a ‘reverse’ 1031 exchange set up, you effectively do the opposite:  you acquire the replacement ‘like-kind’ property first, and then sell your existing property.  The proceeds from the sale in either case are invested into the like-kind, replacement property according to the rules and limits put in place by the IRS.

Here is an excellent infographic of the 1031 exchange process that explains visually what is sometimes difficult to understand with the written word:

http://dailyinfographic.com/1031-exchanges-the-ultimate-guide-infographic

Purpose

My guess is that by now you have a pretty good idea as to why it is sometimes a great idea to enter a 1031 exchange and why the hassle might just be worth it:  deferral of the typical long-term capital gains rate of 20% on your investment gains until you decide otherwise.

Let’s look at the example we used above.  We purchased our piece of commercial real estate for $1M.  Ten years later, we decided to sell our property for a cool $2M.  Excusing all of the associated costs of the transactions, and any alterations to our cost-basis, we have doubled our money!

If we were to sell outright without the expectation of exchanging into our bigger and better property, we would net (approximately) $800k:

Sales Price:  $2M

Purchase Price:  $1M

Difference:  $1M

 

Taxes (@ 20% of $1M):  $200k

Net to You:  $800k

 

If we opted instead to do a 1031 exchange, this example would look like this:

Sales Price:  $2M

Purchase Price:  $1M

Difference:  $1M

 

Taxes (@ 0% of $1M):  $0

Net to You:  $1M

 

It Might Not Make Sense

A 1031 exchange or reverse 1031 exchange may not make sense for you if you have $50k or less in capital gains.  In this case, the processes involved may be too cumbersome, the interface with intermediaries too costly and the tax consequences not damaging enough to justify involvement.

If it does make sense, a 1031 exchange might just be the ticket to advancing your financial goals.  As with all processes, procedures and rules  surrounding your taxes, consultation with the IRS, tax attorneys and/or a 1031 intermediary is imperative to getting the most out of your tax planning and your commercial real estate transactions.

 

Don’t Trust the IRS

We are all practically potty-trained to run everything we do by the experts.  If we are asked to sign a contract, we have to run that by our expert attorney.  If we want to understand the best business structure for tax purposes, we are told to check with our expert CPA (or another kind of attorney:  the expert tax attorney).  You get the idea:  check, check and double-check with those in the know.

In addition to our stable of highly professional professionals, we also have other highly reputable “experts” we should be able to rely on to determine if we are doing the right thing.  If we wanted to figure out what the tax implications and treatment should we want to rollover an IRA for instance, we might think the IRS would have the answers.  Let’s even say that the IRS has spelled out exactly how this IRA rollover should happen, and you diligently follow the documentation and the advice given by the IRS to the letter.  In this case, should we be able to rely on the agency that makes up the rules for the treatment of IRAs to give us sound, sage and legally accurate information?

Apparently not…

Yes, you read that right.  According to one judge, the IRS is not an “expert” in the field of IRAs and how or when to roll them over.

Huh?  Not an “expert”?  If the IRS, the rules maker, is not an expert — then just who is?

The case brought before this judge surrounds a couple and their “rights” to withdraw funds from their IRA once per year, hold these funds for 60 days, redeposit these funds into qualified accounts without incurring taxes or penalties.  The couple in this case relied on a publication produced by the IRS, Publication 590, Individual Retirement Arrangements (IRAs), as their basis for determining the legality of this action.  Simplifying the case quite a bit, here’s what we know:

The husband (a tax attorney himself) had two qualifying IRAs — one traditional, and one rollover.  He withdrew about $65,000 from each IRA within 3 months of each other.  The husband did repay these amounts within the 60 days as stipulated by the law. That’s not the real issue.  The real issue is that he took each of these distributions within 3 months of each other.

Part of the regulation regarding these distributions seems to say that you may not take a distribution like this more than once in a 12 month period.  You remember the husband took two distributions within 3 months of each other.  The court says that both of the husband’s IRAs are to be considered together when deciding if he has violated the 12 month limitation.  The husband says that the 12 month limitation applies to each IRA individually and he did not violate the 12 month limitation for each of his IRAs individually.

The judge ruled against the couple and the couple became liable for taxes and penalties.  In arguing before the court, the couple presented Publication 590.  The court used case law to back up its decision.  The couple had no case law to argue.

When I first read this story, I was outraged that the court would take such a radical stand.  After reading through the decision however, it appears that there is some ambiguity with the law, but the real problem is the IRS Publication 590.  This publication clearly outlines examples where you have two IRAs and you would like to roll these IRAs over.  The publication unequivocally states this is possible and legal.

The moral of this story?  Perhaps just as the judge said, “Taypayers rely on IRS guidance at their own peril.”  Be careful out there.

http://www.forbes.com/sites/janetnovack/2014/04/18/taxpayers-rely-on-irs-guidance-at-their-own-peril-tax-judge-rules/