October 26, 2017
As real estate values continue to grow, owners may be seeking to lock in the gains they have made over the past decade since the crisis. Real estate valuations have grow in virtually all parts of the country, with some areas seeing extremely rapid growth. Unfortunately, a big sale would result in a huge capital gains tax bill. These bills are onerous and can take a huge portion from the gains. Fortunately, the government has created a way to avoid this onerous tax bill through the 1031 exchange provision. Many investors are taking advantage of this provision to avoid taxes and still get the benefit of their investments.
The basic ideas of the 1031 exchange is that the money from the sale of a property can go untaxed if it is reinvested into another property or properties within 180 days. Investors must use the money other real estate if they sold real estate. However, the ruling is fairly broad. For example, you may use the proceeds from selling a warehouse to buy an office building. You may also purchase more than one property if you cannot use up all the funds on your ideal target location. If you take any funds to and distribute them to your personal account, they will still be taxed at the 25% capital gains tax rate.
Imagine an investor buys are $1,000,000 warehouse in 2010. They place $200,000 down and take an $800,000 loan. Over the years the value steadily increases as more e-commerce companies demand warehouses to store inventory in anticipation of deliveries.
By 2017, the value of the warehouse rises to $1,600,000. At the same time, the investor has paid down $200,000 of the loan. If they were to sell the property, they would receive $1,000,000 in proceeds after paying back the bank. This would be an incredible 4x return on the initial $200,000 investment. Now the investor would have $800,000 in profit to do anything they want. Unfortunately, the government will take a $200,000 bite out of those gains through a capital gains tax.
To avoid this draw down, the investor can reinvest through the 1031 exchange provision. They can now purchase a $5,000,000 property by reinvesting the $1,000,000 in proceeds from the property and taking out an 80% loan again.
Now they buy a $5,000,000 office property with higher rents, more cash flow and a more prestigious location that houses the office space of those same expanding e-commerce firms.
1031 exchanges must have a business purpose and must not be for personal use. Residential homes do not count for this tax strategy so individuals and families cannot count on this way to reduce taxes.
Some people set-up a corporation to buy a vacation home and then rent it to others. In this case as long as the structure is set-up correctly, it is possible to use these homes in the 1031 exchange. However, an audit may question this purpose and will require additional documentation. It is best to avoid using vacation homes for 1031 exchanges.
If you intend to use the 1031 exchange, you need to designate an intermediary like a trust company or bank to hold the funds during the 180 days between the acquisition of a new property. Of course you can close on the property before the 180 days but that is the maximum amount of time. During that period, the intermediary holds the funds in trust to be used for the acquisition of the new property.
Overall, 1031 exchanges have been a major boon to the real estate industry. They have help both large institutional investors and small single property investors to reduce their tax burden and grow their holdings over time. Professional real estate investors should be aware of this important provision.