1031 Exchange – What you need to know

A 1031 exchange allows you to defer the capital gains tax due on the sale of a piece of real property by rolling the gain into any other type of real property. A qualified intermediary must complete the 1031 exchange and there are very specific rules that must be adhered to.

The total capital gains tax calculation as of 2013:

• Taxation on depreciation recapture at 25%
• Federal capital gains taxes at 20% (or 15%)
• 3.8% Medicare surcharge tax on net investment income
• State tax rate (0% - 13.3%)

Medicare and Federal Capital Gains tax depend on your taxable income

Single	Married	Cap Gains	Medicare	Combined Rate
$0 - $36,250	0 - $72,500	0%	0%	0%
$36,251 - $200,000	$72,501 - $250,000	15%	0%	15%
$200,001 - $400,000	$250,001 - $450,000	15%	3.8%	18.8%
$400,001 +	$450,001 +	20%	3.8%	23.8%

 

A 1031 Exchange can be an expansion from one property into many, a consolidation from many properties into one or a partial exchange where money is taken out of the exchange.

Cash taken out of the exchange is known as cash boot and will be taxed at the full capital gains tax outlined above.  Mortgage boot is also taxable and will be covered later in this article.

To qualify for a 1031 exchange, the property must meet the following rules:

1. Intent on the property is to hold for investment
2. Facts and circumstances back up intent to hold for investment
3. Paper trail backing up intent to hold for investment

As you can see, intent for the exchanged property is of great concern to the IRS. The time period for which the property must be held for investment is not defined by the IRS. The shorter that time period, the higher the red flag for audit.

Vacation homes can qualify for exchange if the vacation home was primarily held for investment. The vacation home will be considered held for investment if the following requirements are met.

• The relinquished property and replacement property must be held by the taxpayer for a least 24 months.
• Within each of these two 12 month periods, constituting the qualifying use period, the taxpayer must:
  • Rent the property at fair market value for a period of 14 or more days.
  • The taxpayers personal use of the property can’t exceed the greater of 14 days or 10% of the total time rented.

A common question: “How would the IRS ever know if I used the vacation home?”

The IRS has access to anything they need in order to prove their case. This includes access to your ATM records, access to your credit card statements, access to your cell phone records, etc. If you lie to the IRS it constitutes as tax fraud.

Rules for the most common 1031 Exchange, a delayed exchange.

• Time Requirements
  • Taxpayer must identify potential replacement property(s) by midnight of the 45^th day from the sale of the relinquished property.
  • Taxpayer must acquire the replacement property by midnight of the 180^th day or the date the Taxpayer must file its tax return, whichever is earlier.
  • Identification Rules
    • 3 Property Rule – Can identify up to 3 replacement properties with and unlimited total market value. You can also unidentify  as many times as necessary to stay within the 3 property rule. Taxpayer must acquire one of the identified properties.
    • 200% Rule – Unlimited amount of identified properties but the total market value of all identified properties must not exceed 200% of the relinquished property. Taxpayer must acquire one of the identified properties.
    • 95% Rule – Taxpayer may identify an unlimited number of properties with an unlimited total market value. Taxpayer must acquire 95% of the identified properties.
    • Identification must be:
      • Made in writing
      • Unambiguously describe the property
      • Hand delivered, mailed, telecopied, or otherwise sent
      • Sent by midnight of the 45^th day
      • Delivered to the Qualified Intermediary

The Exchange Equation

For a full deferral the taxpayer must meet two requirements:

1. Reinvest all the net exchange proceeds
2. Acquire property with the same or greater amount of debt

Example 1 – No Boot: In this example the replacement property has a higher debt amount and no cash is taken out, so there is no boot and therefore no tax liability.

	Relinquished	Replacement	Boot
Value	$900,000	$1,200,000
- Debt	$300,000	$660,000	$0
- Cost of Sale	$60,000
Net Equity	$540,000	$540,000	$0
Total Boot			$0

Example 2 – Mortgage Boot: In this scenario the replacement property has a lower debt amount creating mortgage boot. So there is a capital gain tax liability on the $40,000 mortgage boot despite the fact that all the proceeds from the transaction were invested in the replacement property.

	Relinquished	Replacement	Boot
Value	$900,000	$800,000
- Debt	$300,000	$260,000	$40,000
- Cost of Sale	$60,000
Net Equity	$540,000	$540,000	$0
Total Boot			$40,000

 

The real power of the 1031 Exchange

If you defer the capital gain taxes, how much does your purchasing power increase?

1st Calculate Net Adjusted Basis
	Original Purchase Price (Basis)	$500,000
	plus Capital Improvements	$50,000
	minus Depreciation	$150,000
	equals Net Adjusted Basis	$400,000
2nd Calculate Capital Gain
	Sales Price	$800,000
	minus Net Adjusted Basis	$400,000
	minus Cost of Sale	$60,000
	equals CAPITAL GAIN	$340,000
3rd Calculate Capital Gain Tax Due
	Recaptured Depreciation (25%)	$37,500
	plus Federal Capital Gain Tax (20%)	$38,000
	plus Medicare Surcharge (3.8%)	$12,920
	plus State Tax (CO 2.9%)	$9,860
	TOTAL TAX DUE	$98,280
4th Calculate After Tax Equity
	Sales Price	$800,000
	minus Cost of Sale	$60,000
	minus Loan Balance	$300,00
	equals Gross Equity	$440,000
	minus Capital Gain Tax Due	$98,280
	equals After Tax Equity	$319,960
REINVESTMENT OF SALE
	After-Tax Equity x 4	$1,279,840
REINVESTMENT OF EXCHANGE
	Gross Equity = Net Equity	$440,000
	Gross Equity x 4	$1,760,000
INCREASE IN PURCHASE POWER		$480,160

 

The equity multiplier mentioned above assumes that that equity from the sale will be used as a 25% down payment on the replacement property keeping the loan to value at 75%.

How to select a Qualified Intermediary (QI)

• Does the QI offer written backing of a large creditworthy entity?
• What is the financial rating and balance sheet of the backing entity?
• Does the QI conduct due diligence on the depositories holding the funds and monitor them?
• Does the QI offer segregated accounts?
• Does the QI offer a qualified escrow account?
• Does the QI offer a qualified trust account?
• Does the QI have sufficient fidelity bond coverage?

The Neir Team Endorses Scott R. Saunders with Asset Preservation, Inc as a Qualified Intermediary. www.apiexchange.com

The information in the article was provided by Scott E Saunders with Asset Preservation, Inc.