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.

 

The Missing Pieces

I was on the phone the other day speaking with a tax strategist. Not a CPA (well, he is a CPA, but not for the purposes of this call), not a bookkeeper, not a tax preparer, but a tax strategist. Just one more professional that I have found a need for moving forward. Why? Well, that’s for another discussion. I want to focus on what this tax strategist said to me that struck a chord. It might strike a chord with you too.

Opening our discussion, we initially spoke about being a full-time W-2 worker and what kinds of tax limitations that presents. That’s when the pearl of wisdom erupted from this tax strategist as he drew a very simple analogy.

“Remember when we were kids and we played with those gigantic 4 or 5-piece puzzles?”, he asked. I answered in the affirmative when he said that tax strategy is just like those gigantic puzzles. In order to complete the puzzle, we need all of the puzzle pieces. The puzzle will just not fit if we don’t have all of the pieces. That seemed logical and easy understand. Then, like a ton of bricks, he said that in order to make ANY tax strategy work, you must have all of the puzzle pieces. The important thing here is that as a W-2 worker, you don’t have all of the tax strategy puzzle pieces!

As a W-2 employee, even with a mortgage on your primary residence, you don’t have all of the pieces. He went on to say that the two important pieces that are missing in this scenario are a business and/or a real estate investment. Without those two critical pieces of our tax strategy puzzle, we will not have a satisfactory tax strategy. For it is the business owner and the real estate investor that have the ability to write off even the most mundane expenses. It is the real estate investor that has the ability to take depreciation. As a W-2 employee, you can’t do those things very well.

Each of these incentives even make sense from a government policy standpoint, right? The government wants you to start a business. The government is happy when you invest in real estate, so they “help” you do that with tax policy and incentives. So if you want to minimize your tax burden and formulate a better tax strategy moving forward, remember that starting a business and investing in real estate (and especially commercial real estate) are your missing pieces.