02/02/2017
CALIFORNIA 1031 EXCHANGE REAL ESTATE LAWS FOR 2017
DO YOU KNOW WHAT A 1031 EXCHANGE IS AND WOULD IT BENEFIT REAL ESTATE INVESTMENT PORTFOLIO?
What is a 1031 Exchange?
The term 1031 Exchange (aka a“Starker exchange” or a “Like Kind exchange”) is defined under section 1031 of the IRS Code. (1) To put it simply, a 1031 exchange allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long another “like-kind property” is purchased with the profit gained by the sale of the first property.
A1031 exchange has more benefits than just saving yourself from taxes in California.
A 1031 exchange can allow a real estate investor to shift the focus of their investing without incurring the tax liability. For example, perhaps you are investing in properties that are low-income and thus high-maintenance. You could exchange the high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes. Or perhaps you want to move your investments from one location to another without the IRS knocking. The 1031 makes this possible.
Traditionally, a 1031 exchange is where one property is literally swapped for another property of like-kind. However, the likelihood that the property you want is owned by someone who wants your property is really, really unlikely. According to Forbes Magazine related study, this is why “the vast majority of exchanges are delayed, three party, or Starker� exchanges (named for the first tax case that allowed them). In a delayed exchange, you need a middleman who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you. This three party exchange is treated as a swap.”
When to do a 1031 Exchange?
When you sell an investment property, even if you weren’t the one who initially purchased, you end up on the hook to pay capital gains tax.
If you’ve made some bad investments, or you just have bad luck, selling your investment can cost you more than you make.
But, if you own a rental property that is worth significantly more today than what you (or the original owner) purchased it for, you can make a killing by doing a 1031 exchange.
The big question: how should you do your 1031 exchange in 2017?
How To Do a 1031 Exchange Right Now?
To do a 1031 exchange effectively, you must exchange one property for another property of similar value. In the process you avoid capital gains, at least for a while.
An investor will eventually cash out and pay taxes, but in the meantime, an investor can trade properties without incurring a sudden tax obligation. It’s an important tool for real estate investors that has become a bulls-eye for tax reform evangelists.
However, the 1031 Exchange Rules require that both the purchase price and the new loan amount be the same or higher on the replacement property.
That means that if an investor were selling a $1 Million property in San Jose that had a $650,000 loan, they would have to buy $1 Million or more of replacement property with $650,000 or more leverage.
There are 4 types of 1031 exchanges available to the investor;
1 – Simultaneous Exchange
This allows investors to relinquish and close on a replacement property in the same day. Originally, this is what a 1031 exchange was–a direct exchange between two parties. Today, this type of exchange isn’t very common. Why? Because what are the chances that the person who owns the exact property you want also wants the exact property you own? It can happen, but the possibility is pretty slim.
2 – Delayed Exchange
This type of 1031 exchange is the most common. It allows the investor to sell their investment property first, and find a replacement property within a certain amount of time. Note: we’ll discuss the rules associated with a Delayed Starker Exchange in the next section.
3 – Reverse Exchange
In theory, the reverse 1031 exchange is very simple: you buy first and you pay later. What makes it difficult, however, is that this type of exchange must be an all cash purchase AND most banks won’t lend to you. Why is it so difficult to get a loan? It’s because you cannot be on title to the replacement and the relinquished property at the same time. The solution: you can create an LLC that can take title to the replacement property. Once you sell the original property, you can transfer the title of the replacement property into your name.
4 – Construction/Improvement Exchange
There are a lot of investors that sell a property, and realize that the one they want to buy costs less than the one I relinquished. What do you do? Well, since paying taxes is out of the question…you might consider doing a Construction or Improvement Exchange. This type of exchange allows you to use the remaining funds to build or improve on the property you want to buy.
1031 Exchange Rules You Must Follow?
Rule 1: Like-Kind Property
To qualify as a 1031 exchange, the property being sold and the property being acquired must be “like-kind.” This is a very broad term, meaning that both of the properties must be “the same nature or character, even if they differ in grade or quality.” You can’t exchange farming equipment for an apartment building, because they’re not the same asset. In terms of real estate, you can exchange almost any type of property, as long as it’s not personal property.
Examples:
1. Exchanging an apartment building for a duplex would be allowed.
2. Exchanging a single family rental property for a commercial office building would be allowed
3. Exchanging a rental property or vacation rental for a restaurant space would be allowed.
**It’s important to note that the original and replacement properties must be within the U.S. to qualify under section 1031.
Interesting fact: When using a Starker Exchange doesn’t have to be a 1-1 exchange. For example, you can exchange one property for multiple replacement properties and vice versa: you can exchange multiple properties and for one larger property. As long as the new properties are like your original properties, you’re good to go. Do yourself a favor and get a good qualified intermediary to assist you.
Rule 2: Investment or Business Property Only
A 1031 exchange is only applicable for Investment or business property, not personal property. You can’t swap one primary residence for another.
Rule 2 Example:
1. If you moved from California to Georgia, you could not exchange your primary residence in California for another primary residence in Georgia.
2. If you were to get married, and move into the home of your partner, you could not exchange your current primary residence for a vacation property.
3. If you were to own a single-family rental property in Idaho, you could exchange it for a commercial rental property in Texas.
Rule 3: Greater or Equal Value
In order to completely avoid paying any taxes upon the sale of your property, the IRS requires the net market value and equity of the property purchased must be the same as, or greater than the property sold. Otherwise, you will not be able to defer 100% of the tax.
For example, let’s say you have a property worth $1,000,000, and a mortgage of $500,000. To receive the full benefit of the 1031 exchange, the new property (or properties) you purchase need to have a net worth of at least 1 million dollars, and you’ll have to carry over at least a $500,000 mortgage. It’s important to note that the $1,000,000+ value, and $500,000 mortgage, can go towards one apartment building or three different properties with a total value of $1,000,000+. (FYI: Acquisition costs, such as inspections and broker fees also apply toward the total cost of the new property.)
Rule 4: Must Not Receive “Cash Boot”
You, the Taxpayer Must Not Receive “Cash” from an exchange in order for a Section 1031 exchange to be completely tax-free. Any cash received is taxable to the extent of gain realized on the exchange. In other words, you can carry out a partial 1031 exchange, in which the new property is of lesser value, but this will not be 100% tax free. The difference is called “Boot,” which is the amount you will have to pay capital gains taxes on. This option is completely okay, and often used when a seller wants to make some cash, and is willing to pay some taxes to do so.
An example of this would be if your original property is sold for $1,000,000 and the property you wish to exchange under section 1031 is worth $500,000, you would need to pay the normal capital gains tax on the $500,000 “cash boot.”
For more information regarding 1031 Exchanges contact the Etchart Consulting Group Inc. in Clovis California. Email us at [email protected]. The first consultation to asses your situation is free of charge. This information was compiled from different private and public sources by the Etchart Consulting Group Inc. for the reading pleasure of our clients and followers.
