REALTOR® Magazine-Daily News-1031 Exchanges: It's a Tax Thing

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Daily Real Estate News | November 19, 2007 | 1031 Exchanges: It's a Tax Thing
1031 exchanges can be a powerful tool for investors who are either buying or selling, and a specialty in this area can give you a great pipeline of business in a tough market, Rochelle Stone of qualified intermediary Starker Services Inc., Los Gatos, Calif., said Friday at the 2007 REALTORS® Conference & Expo in Las Vegas.

“Exchanges aren’t just for sellers,” Stone said. "At a time when there are so many listings, investors may want to buy, but hesitate because of the taxes they will incur if they sell their current properties.”

She suggests that you approach owners and show them that by using a 1031 exchange they can buy a property that better suits their current investment goals without incurring current taxes.

And because of depreciation recapture provisions, which tax accumulated depreciation, an exchange may be a good option even if an investor isn’t realizing much of a gain on a sale, noted John Mangham, also of Starker Services. For example, an investor may think that if he is only realizing a $20,000 gain on a sale, it’s not worth doing an exchange to save $3,000 ($20,000 X 15% capital gains tax rate = $3,000).

However, if the investor has taken $50,000 of accumulated depreciation on the investment property, that amount would be recaptured as gain at the time of sale and generate a tax bill of $12,500 ($50,000 X 25% tax rate on depreciation = $12,500). “Without an exchange, you’re giving most of your profit to the government,” he said.

But exchanges work only if you know the rules. While Stone doesn’t advise trying to explain the details of a 1031 to clients (“Just say ‘it’s a tax thing I heard about and you should check it out,’” she suggested), you do need to know the basics.

Properties in an exchange must be used for business or trade or held as an investment. A primary residence or vacation home used primarily by the owner does not quality. Also note that just renting out a vacation home for a few months probably won’t be enough to quality for an exchange, warned Mangham.

Exchanges must be between like-kind properties. That doesn’t mean condo for condo, but one kind of real property — including land — for another. You can also by a fractional interest in a larger property through a TIC (tenant-in-common) investment, noted Mangham.

Speed is of the essence. For an exchange to meet Internal Revenue Service regulations, you must identify replacement properties within 45 days of relinquishing the sale property and close on a property within 180 days. (Also note that the 45 days and 180 days run concurrently.) “Meeting this timeframe is the toughest part of doing a 1031,” says Stone.

Shop for properties early and often, says Mangham. The possible replacement properties you identify must be either three properties of any fair market value or any number of properties valued at no more than 200 percent of the value of the relinquished property.

This doesn’t mean you have to buy all these properties; just that this is the maximum number you can identify under IRS rules. And don’t be afraid to make earnest money deposits to hold potential properties before you’ve sold what you own now, says Mangham. You call get a refund of the earnest money you put in when the transaction closes.

“The future of real estate belongs to the flexible, and 1031s give a great deal more flexibility in helping investor clients own the best property for them,” concludes Stone.

— REALTOR® Magazine Online