Financial Resource

Too often a successful real estate investment comes at the expense of something else which is very valuable: time.  As buildings age the amount of time needed to address the rising needs of tenants, as well as increasing maintenance costs, chips away at what might otherwise have long been a great investment.  As a remedy to these problems real estate owners are looking to IRC §1031 tax deferred exchanges for a solution.

Real estate owners have had the option of deferring the recognition of a capital gains tax by exchanging real estate, rather than engaging in a sale and subsequent purchase, since 1921.  And although much has changed since then, the basic concept remains: A properly structured tax deferred exchange under section 1031 of the Internal Revenue Code allows an owner of real estate to defer the recognition of a capital gains tax normally recognized on the sale of real estate, if the real estate owner buys a like kind property of equal or greater value and uses all of its cash equity in the subsequent purchase.

Simply put, taxpayers are selling their management and cost intensive properties, buying low or no management properties, and utilizing an exchange so as to not realize any capital gains tax.  Many real estate owners mistakenly believe that the “like kind” requirement means that if they are selling an apartment building they must also buy an apartment building.  Nothing could be further from the truth.

Like kind refers to any property held for business or investment purposes.  What that means is that a real estate investor may sell an apartment building and buy, for example, a strip mall, office building, or a net leased restaurant.  As long as the property being sold and the property being purchased are real estate, they can be exchanged, no matter what the property use is.  Of course there are some limitations for this general rule.  For example, you may not sell your primary residence and structure it as an exchange.

An exchange is also an important part of retirement and estate planning.  For example, an owner of an apartment building may choose to structure the sale of that building as an exchange and purchase a single family home on a golf course, and a net leased pharmacy.  To satisfy the requirement that all properties sold and purchased in an exchange are business or investment properties the single family home is leased to a tenant through a management agent for a period of several years.  Thereafter, the intent of the real estate owner changes from an investment use to a personal use, and the property is used as a primary residence or vacation home.  The net effect is that the investor has sold a high maintenance and cost building and exchanged it for a management free net leased investment, as well as a potential retirement or vacation home, all without incurring any capital gains tax.

Although the rules to obtain a full deferral of a gain require that you use 100% of your equity to purchase the replacement property, there are several options for obtaining the use of those funds.  First and foremost, there is always the option of only structuring an exchange with a portion of the funds received from a sale, in which case an investor is taxed on the amount that was not reinvested.  A much better approach is to use 100% of the funds received from the sale property to purchase a replacement property structured as an exchange, and thereafter refinance the replacement property to gain the use of those funds.  The income from the replacement property will take care of the debt service on the financing, and the investor is able to use these refinance funds tax free.

There are a myriad of ways in which an IRC §1301 exchange can help a real estate investor.  In order to obtain the maximum benefit it is always useful to obtain information from a trusted qualified intermediary and review it with your tax and/or legal counsel.

Legal 1031 Exchange Services, Inc.

877/701-1031

todd@legal1031.com

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