§1031 Exchange Intermediary

I thought for my first blog post I would provide an overview of what Section 1031 tax-deferred exchanges are all about. This is going to be geared toward those folks who have never heard of tax-deferred exchanging, or perhaps they've heard of them but don't know much at all about them. Let's start out with some background:

EXCHANGES ARE A POWERFUL TAX STRATEGY

Tax-deferred exchanges have been a part of the tax code since 1921 and are one of the last significant tax advantages remaining for real estate investors.

One of the key advantages of a §1031 exchange is the ability to dispose of a property without incurring a capital gain tax liability, thereby allowing the earning power of the deferred taxes to work for the benefit of the investor (called an “Exchanger”) instead of going to the government. The reason the tax deferral is allowed is based on the theory that the investment itself does not actually change; merely the form of the investment changes. I like to use the analogy of an IRA rollover. If you do it properly, you can roll over the proceeds of an IRA with one company to an account with a new company. Part of that process is that you cannot receive the funds yourself; they have to go from the old company to the new one. Tax-deferred exchanging is similar in that you cannot receive, or have control over, the proceeds of the sale of the property you are exchanging out of.

So, what's the point? The point is that a lot more of the seller's proceeds can go toward the purchase price of the new property. In future blogs, I'll give you a more detailed example, but just imagine this for now - a seller sells a property for $100,000 that has a mortgage balance of $50,000. After paying off the mortgage and the costs to sell the property, there is $40,000 remaining. If Mr. Seller takes that money and invests it in a new property, he will be left with nothing to pay his capital gain taxes (federal and state), plus the cost of depreciation recapture.

Let's break this down. First, let's deal with depreciation recapture. Depreciation is a write-off that is allowed for investment properties whereby the investor can depreciate the "improvement" portion of his investment (i.e., the building). It does not apply to land. Depreciation is great during the time the investment is owned because it offsets income from the property (and other income as well), but when the property is sold, recapture can be a bear. All of the depreciation taken during the course of ownership must be "recaptured" on the tax return and repaid at a rate of 25%. How much was this investor's depreciation recapture? It depends upon how long he owned the property. For our example, we're going to assume that this investor paid $60,000 for this property. If it appreciated from $60,000 to $100,000 and it's in Iowa, chances are good that he's owned it for a while. My HP12c tells me that, at 4% annual appreciation, it would take 14 years for a property to rise from $60,000 to $100,000. At today's depreciation rates, this investor would have something along the lines of $20,000 of depreciation to recapture. Twenty-five percent of that amount is $5,000.

Now we need to determine the amount subject to capital gain tax. Federal capital gains are currently taxed at 15% with few exceptions. How much is the seller's gain? Paid $60,000, sold for $100,000, there's $20,000 of depreciation being recaptured; his remaining gain would be $20,000. 15% of $20,000 is $3,000 that he'd have to have available come April 15.

Moving on to state capital gain rates. Of course, different states have different rates. Since I do a majority of Iowa tax-deferred exchanges, I'm going to use Iowa's rate, which is 8.98% pretty much across the board. We'll round to 9%. The 9% applies to the entire $40,000 in gain, so that's another $3,600 to taxes.

So let's total it up. Federal capital gain tax = $3,000; state capital gain tax = $3,600; depreciation recapture = $5,000, for a grand total of $11,600. Bear with me and let me round that up to $12,000 to see the effect.

If the investor held back $12,000 from his $40,000 to pay taxes, he could only reinvest $28,000. If he used that as a 20% down payment on a new property, he could buy property worth $140,000. On the other hand, if he used the provisions of Internal Revenue Code Section 1031, he could reinvest the entire $40,000 because all of the taxes and recapture that we just calculated would be deferred. Using $40,000 as a 20% down payment, he could buy property worth $200,000. Now, if you are an investor reading this, would you rather have a $200,000 property with $40,000 in equity, or a $140,000 with $28,000 in equity? And if you are a real estate agent reading this, would you rather sell a $140,000 property to this investor, or a $200,000 property? The answers to both of those questions are a couple of the reasons that Section 1031 tax-deferred exchanges make so much sense.

Hope this wasn't too dry. Exchanges can often be very simple, but they can sometimes be extremely complex. Make sure that you are working with someone who knows how to handle the exchange for you. We, of course, recommend Iowa Equity Exchange! We can perform exchanges anywhere in the United States, not just Iowa. If you have any questions about exchanging, please check out our web site or give us a call.

Ken Tharp

Providing Qualified Intermediary services for Section 1031 tax deferred exchanges all over the United States. Headquartered in Iowa, our services are available in Missouri, Kansas, Nebraska, Colorado, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, and all other states.

INTEGRITY.  PRECISION.  SECURITY.