The profitable sale of an investment property presents a good news/bad news situation for many investors. The good news is that the property was sold for more than the purchase price, which means that the transaction was profitable. But, that same profit (or “gain”) can be accompanied by a big income tax bill on their next tax return, which can reduce its size significantly.
There are a number of strategies that sophisticated real estate investors use to reduce or defer their tax bill, one of which is referred to as a “1031 Exchange.”
What is a “1031 Exchange”
A 1031 Exchange, sometimes called a “tax deferred exchange” or “like-kind exchange” is named after the section of the United States Internal Revenue Code (“IRC”) that permits it. Under the rules outlined in this section, a property owner is able to defer the taxes on a profitable real estate sale as long as the proceeds are reinvested or “exchanged” into a new property (the “replacement property” or “Exchange Property”) that is considered to be “like kind” to the sold property (the “relinquished property”) and held for productive use.
For investors, the obvious benefit of the 1031 Exchange program is that it allows their property investment portfolio to grow tax free over time. But, there are a number of rules and regulations that must be followed to complete a 1031 Exchange successfully and receive full tax deferral. If one of them is missed, the transaction could become taxable. These rules can be confusing so we use a simple test to determine the potential benefit of utilizing this program. We call it the “1031 Exchange Napkin Test.”
What is the Napkin Test?
The “Napkin Test” is a simple way to determine the amount of gains that an investor (the “Exchangor”) has to defer in 1031 or “Like-Kind” Exchange. It focuses on three important rules that must be satisfied in the transaction:
Rule 1: The New Property Must Be of Equal or Greater Market Value
To satisfy 1031 Exchange Rules, the Replacement Property must have a value that is equal to or greater than the value of the Relinquished Property.
If this condition is not met, the Exchanger is deemed to have acquired a gain, which is taxable. There are, however, some transactional expenses that could reduce this amount, including but not limited to; title insurance premiums, closing costs, real estate broker’s commission, recording fees, and qualified intermediary fees.
To illustrate this point, assume that a Relinquished Property is sold for $1,000,000 and the proceeds are used to acquire a $900,000 Replacement Property. The $100,000 difference could be considered a gain and the IRS may be entitled to collect taxes on it.
2. Trade up or Equal in Equity
On top of the requirement that the Replacement Property be of equal or greater value, there is an additional requirement that states the amount of equity to be reinvested must be be equal to or greater than the equity from the Replacement Property.
For example, if the original purchase of the property included $250,000 in equity and the purchase of the Replacement Property included only $200,000 in equity, the $50,000 difference is taxable. The calculation of equity can be a bit complicated, but it includes deductions for mortgage boot, closing costs, and sales expenses from the sales price.
3. “Boot” is Taxable
In a typical transaction, the sale proceeds from the Relinquished Property are first used to pay off the mortgage balance. If the mortgage balance on the Replacement Property is not equal to or greater than the mortgage balance from the Relinquished Property, the difference is considered to be “boot” and it is taxable.
For example, assume that the Relinquished Property sold for $1M and $750k was used to pay off the mortgage balance. If a Replacement Property is purchased for $1.5M and the mortgage is $700k, the $50,000 difference is “boot” and the Exchangor will be required to pay taxes on it.
Again, we use these three “rules” to determine the amount of gains that could potentially be deferred when considering entering into a 1031 Exchange. But, these aren’t the only considerations.
Other 1031 Exchange Considerations
If the property passes our initial “Napkin Test” there are a number of other items that must be considered before fully committing to the 1031 Exchange transaction.
Because there are so many rules that must be complied with, the 1031 Exchange Process can be complicated. As such, it is a best practice to work with an expert, or “Qualified Intermediary” to complete it. Under Treasury Regulations section 1031(k)-1(g)(4), a Qualified Intermediary is any person who is “not the taxpayer or a disqualified person” who “enters into a written agreement with the taxpayer (the “exchange agreement”) and, as required by the exchange agreement, acquires the relinquished property from the taxpayer and transfers it to the buyer. Then they hold the exchange funds in escrow. When the Replacement Property is identified, they use the funds to buy it and then transfer it to the to the taxpayer.”
In other words, the role of the Qualified Intermediary is to step in the middle of the transaction and ensure that the Exchangor completes the transaction in full compliance with 1031 Exchange rules. To do so, they acquire the Relinquished Property from the seller and transfer it to the buyer. In addition, they purchase the Replacement Property and transfer it to the Exchangor. In so doing, they prevent the “constructive receipt” of funds by the Exchangor, which keeps the transaction tax deferred.
One of the complicating factors of a 1031 Exchange is the timing of the transaction. The IRS Tax Code lays out specific rules regarding the time limits on the transaction and the time frame in which it must be completed. At a high level, the rules state that the potential replacement property must be identified within 45 days of the sale of the Relinquished Property. In addition, the closing of the purchase must occur within 180 days of the sale of the Relinquished Property.
Competition for Replacement Properties, especially the good ones, can be significant so the timing component can be more difficult to meet than it seems. On occasion, some Exchangors can find themselves pressed for time and willing to settle for any property, which is not the preferred scenario.
The term boot (“taxable boot”) refers to any property received in a 1031 Exchange that is not considered “like-kind” to the Relinquished Property. It could come in the form of cash, debt relief, non-qualified property like stocks and bonds, real property, or other personal property. No matter the type, boot is taxable and it must be avoided to ensure the exchange is fully tax deferred.
There are four types of 1031 Exchanges. The “delayed” exchange is the most common, but there are three others that could be used depending on the Exchangor’s individual needs and circumstances:
A Simultaneous Exchange is exactly what it sounds like. In it, the sale of the Relinquished Property and the purchase of the Replacement Property happen on the same day.
A Reverse Exchange is the opposite of a Delayed Exchange. In it, the Replacement Property is purchased before the Relinquished Property is sold. The same timing rules apply, but also in reverse. The Relinquished Property must be identified within 45 calendar days and sold with 180 calendar days.
Construction / Improvement Exchange
A Construction Exchange is used when there is some amount of repair or replacement that needs to be completed on the Replacement Property. In it, the investor sells the Relinquished Property, identifies a Replacement Property, and places it into the hands of a Qualified Intermediary (QI). While in the QI’s hands, the investor can use the sales proceeds of the Relinquished Property for renovations on the Replacement Property. Upon completion, they will take possession of the Replacement Property under three conditions:
- It must be “substantially the same” as it was before the renovations;
- Construction must be completed within 180 days of the Relinquished Property’s sale date.
- The Replacement Property’s value must be equal to or greater than the Relinquished Property.
Again, the decision about which type of exchange to use will depend on the unique needs and requirements of the investor and the transaction. In many cases, a Delayed Exchange will suffice, but one of the other options can be used if the circumstances dictate.
Interested in Learning More?
The exchange of investment real estate can be a great way to maximize tax-free wealth, increase cash flow, avoid capital gains taxes, and grow a real estate portfolio. The “Napkin Test” is a good first step in determining whether or not a 1031 Exchange is a good idea, but it isn’t the only one. There are further steps that need to be taken to ensure that beneficial exchange strategies are being followed.
To determine the taxes that may be due during an exchange transaction, the following calculations are required: the realized capital gain from the sale of the relinquished property; the amount of taxable boot, if any; and any additional tax issues that may offset any current capital gain tax liabilities. To maximize the benefits of the 1031 Exchange and to ensure that all rules and regulations are followed, a tax advisor should be consulted.
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
We have a significant amount of experience working with 1031 Exchange buyers and sellers. Whether you are just getting started or searching for ways to diversify your portfolio, we are here to help. If you would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.