How To Evaluate Investment Property

A 1031 tax deferred property exchange is one where capital gains tax deferral is available to real estate owners when they sell their investment, rental, business or vacation real estate, and reinvest the net proceeds in other real estate. Real estate held for these purposes are called like-kind or 1031 properties.

Simply put, a 1031 exchange is a way a real property owner can disposes of one property and acquires another without paying any capital gains tax on the transaction by deferring the tax on the exchange indefinitely. This is achieved by meeting the requirements of the Internal Revenue Code (IRC) 1031 exchange within the specified time period.

The time period set is a maximum of 180 calendar days from the closing of the original sale to complete the purchase of the like-kind property. Anyone wishing to utilise the provisions of 1031 must designate candidate properties and properly inform the IRS of these properties within the first 45 days. If the exchanger is to purchase more than 3 properties the price of the exchange properties must not exceed 200% of the price of the property sold but purchases of up to three properties can be purchased in exchange for the property sold with no limit on their market value.

The money from the original sale is held in trust until all the requirements of a 1031 transactions are meet and, if no new properties are identified in the first 45 days or no designated transaction is completed during the full 180 day period, the trust will be liquidated and the sale proceeds will be taxed at the existing capital gains rate. (always consult your CPA for specific tax advice)

The basic requirements of a 1031 exchange are;

Both the sold property and the purchased property or properties must be like-kind. Like-kind is a wide group and open to just about any type of investment or business property. It does not include chooses in action, notes, bonds, stocks, interest in a partnership, personal property, certificates of trust, etc.

Like-kind does not mean an investor selling a parking lot has to purchase another parking lot to qualify. He can buy a different property as long as it qualifies under the 1031 exchange arrangement.

The property sold and the property purchased must be for business or investment use and must be so for a minimum period of 1 to 2 years. The new property can’t be purchased for immediate resale and can’t be used for personal or use for more than 14 days per year or 10% of the number of days the property has been rented in a year.

You must use a qualified intermediary or facilitator for your exchange. You must also use a qualified escrow agent and have no actual or constructive rights to the proceeds of the sale of the surrendered property.

A 1031 exchange agreement between the exchanger and the intermediary is a document where the exchanger gives the intermediary the right to acquire the relinquished property from the exchanger and pass it on it to the buyer. Some of the other documentation required are 1031 exchange escrow agreement, 1031 exchange amendment and assignment to roll over the surrendered property and the 1031 exchange amendment and assignment for the purchase of the identified substitute property.

Main Types of Exchange

1. Simultaneous exchange – is where the exchange property and the replacement property are switched over on the same day.

2. Delayed Exchange – or a Starker Exchange as it is also known as, is where the exchange takes place after the closing of the exchange property. There are strict time frames on these exchanges that must be adhered to.

3. Reverse Exchange – is where the replacement property is purchased prior to the exchange property being sold.

4. Improvement Exchange – is where the purchaser arranges for improvements on a property prior to receiving it as a replacement property. The regulations do not allow for improvements after exchange to be included in a 1031 exchange.

Advantages of Exchange

1. The Exchanger will have more buying power because the federal income taxes are deferred. This will enable him to leverage himself up greater than he could have he paid the tax liability. The additional equity to reinvest will make him a more solid buyer and help him get easier financing.

2. Investors can do exchange after exchange to create a pyramiding effect. This tax liability is forgiven upon the death of the investor as the heirs get a stepped up basis on the inherited property.

3. The Exchanger will have greater selling power because he does not have to inflate the sales price to try to cover some of the capital gains that would normally be due upon the sale of an investment property. It will enable him to be more flexible with the selling price.

4. The Exchanger can acquire a replacement property with greater income potential. He can sell raw land and acquire income-producing property. Perhaps, he wants to acquire a building with additional units or in an easier to rent location.

5. The Exchanger has the opportunity to consolidate several hard to manage properties in one easy to manage property or diversify several small properties into one large property. It provides an excellent opportunity to relocate or expand a current business or investment.

6. An exchange can also help an investor acquire a less management intense property.

Limitations

1. Three Property Rule – Exchanger may identify up to three properties regardless of their fair market value. The Exchanger is not obligated to purchase all three properties but must purchase at least one of the three identified properties. For example, if selling a relinquished property for $100,000, three replacement properties can be identified with a combined fair market of $750,000.

2. 200% Value Rule – Exchanger may identify more than three properties but their combined or fair market value cannot exceed double (200%) the fair market value of the relinquished property. For example, if a relinquished property was sold for $100,00 and four or more replacements are identified, their combined fair market value cannot exceed $200,000 with 200% or double the sale price of the relinquished property.

Exceptions to the Three Property Rule and the 200% Value Rule:

1. Any replacement property acquired within the 45-day Identification Period will be treated as properly identified, regardless of whether or not it is within the Three Property Rule or 200% Value Rule.

2. If the Three Property Rule and 200% Value Rule are dishonoured, the property will still be treated as properly identified if 95% of the combined fair market value of the identified replacement property has been obtained.

Need to sell an existing property or looking for a property?

Always consider Ron Henderson and Multi Real Estate Services as your source for real estate investment consultation.

Licensed Real Estate Broker with the Calif. Dept. of Real Estate