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1031 Exchange Examples
Christina’s First Investment
After college, Christina chose to continue living with her parents, while she began saving for her future. In time, she had saved $20,000. With the aid of bank financing, Christina invested in her first rental property. She bought a modest 2-bedroom, 1½ bath condo near the local community college for $100,000. Over the time Christina owned the property, she had taken $25,000 in depreciation, paid $25,000 toward her initial mortgage, and her investment grew to $115,000. She decided that it was time to upgrade her investment.
After consulting with her tax and legal advisors, Christina learned that if she sold the condo outright, without the use of Section 1031, she would have to pay depreciation recapture taxes on the $25,000, as well as capital gains taxes on the $15,000.
X 25% Federal The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation Recapture $6,250
X 5% State The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation Recapture $1,250
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$15,000 Calculation of the difference between the sales price of the relinquished property less selling expenses and less the adjusted basis of the relinquished property. Capital Gain s
X 15% Federal Calculation of the difference between the sales price of the relinquished property less selling expenses and less the adjusted basis of the relinquished property. Capital Gain s Tax $2,250
X 5% State Calculation of the difference between the sales price of the relinquished property less selling expenses and less the adjusted basis of the relinquished property. Capital Gain s Tax $750
TOTAL TAX BITE $10,500
Christina’s tax advisor showed her that she would lose approximately 2/3 of her investment gains to taxes if she were to sell the property outright. She had a good outcome with this initial investment and her tax advisor suggested that she structure the sale as part of a Section 1031 exchange, rather than an outright sale. Christina and her tax advisor crunched the numbers again, and learned:
Christina’s original investment $20,000
Equity from mortgage payments made $25,000
Equity from capital gains $15,000
TOTAL EQUITY AVAILABLE $60,000
Christina agreed that a 1031 exchange was the best strategy for her, and she listed her modest condo for sale. Because it was well-maintained and near the community college, there were multiple offers. Christina promptly sought referrals from her tax and legal advisors, who both recommended the same Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary (QI). The QI worked closely with Christina’s advisors and the closing agent to prepare for the sale of her property. Christina was able to net $60,000 after all closing costs, and the closing agent sent this entire amount directly to Christina’s QI.
It is important to note that Christina must use all of her equity in the property – including her original $20,000 investment, the $25,000 paid off of the mortgage balance, and the $15,00 in capital gain – toward the purchase of her replacement property to defer all taxes. This is because if Christina had sought to withdraw her initial investment, the IRS would have characterized those funds as profit rather than the return of her original investment. This would have created a taxable event, which Christina was seeking to avoid.
Christina spent the next several weeks working with her real estate advisor, knowing that she had 45 days to provide her QI with a short list of potential replacement properties. Read this article for more information about the identification rules.
Working with her real estate advisor, Christina found a newer 3-bedroom, 2½ bath townhouse, with a garage, on a quiet street in a desirable neighborhood. Using the $60,000 from the sale of her first condo, Christina financed the remaining $240,000 needed to complete the acquisition of the $300,000 townhouse. Christina’s QI again collaborated with her advisors and the closing agent, and Christina was able to complete the acquisition of her second investment within the exchange period. Read for more information about exchange deadlines.
Consolidating Kelly’s Portfolio
Like Christina, Kelly began investing in real estate right out of college. Over the years, Kelly has built a portfolio of six condos, townhouses, and single-family rentals in four towns near her home. But managing all of these properties was proving to be difficult and time consuming. Kelly wondered whether there was an easier way.
Kelly consulted with her tax and legal advisors, both of whom encouraged her to consider a Section 1031 exchange. Kelly’s portfolio is worth about $800,000, and if she were to sell outright, she would face about $275,000 in state and federal capital gains and depreciation recapture taxes. Kelly agreed that a 1031 exchange was the right way to go, and listed her properties with her local real estate agent. The listing indicated that they could be bought as a bundle, or individually.
Kelly also consulted with the QI that her advisors recommended. During the consultation, the QI pointed out that if she sold the various properties individually over a period of time, but still wanted to use the proceeds of all of them for one purchase, her identification and exchange periods would commence with the sale of the first property. The QI also pointed out that, depending on the timing of the sales, and the possibility that Kelly might want to acquire multiple replacement properties, Kelly could consider establishing multiple exchange accounts.
Fortunately, Kelly’s properties were all desirable, and her broker was able to secure one buyer for the entire portfolio. Kelly and her broker provided the sale contract to the QI, who prepared the necessary exchange documents. The QI worked closely with Kelly’s advisors and the closing agent to ensure that the net sale proceeds were sent directly to the QI rather than to Kelly or her attorney. At closing, the net proceeds of $700,000 (after expenses and paying off mortgage debt of just under $100,000) were sent to the QI, properly starting Kelly’s 1031 exchange.
Working with her real estate advisor, Kelly found a mixed-use, multi-tenant building near her home, consisting of two apartments, two stores, and three townhouses. Using the $700,000 in exchange proceeds, Kelly financed the remaining $900,000 needed to complete the acquisition of this property. (It is important to note that if Kelly wants the full benefits of a 1031 exchange, she would need to replace the debt paid off at the sale of her original property. Kelly obtained a new loan, but she also could have replaced the original debt with fresh cash. Further, Kelly is leveraging her equity to acquire a new property worth significantly more than the one she sold.) Kelly’s QI again worked closely with her advisors and the closing agent, and Kelly was able to complete the acquisition of her consolidated investment within the exchange period.
Grandpa’s Estate Planning and Diversification
Grandpa Al has owned a small shopping center for many years. He had no immediate need to sell the shopping center until he spoke with his new estate planning attorney. During the consultation with the estate planning attorney, Grandpa Al revealed that his Will provides that his four grandchildren will inherit the shopping center. The estate planning attorney pointed out that having four family members inherit one property was a recipe for a new family feud. He pointed out that the four grandchildren would likely have different ideas about what to do with the shopping center, and that he should consider restructuring his real estate investment. The estate planning attorney invited his tax attorney partner into the consultation, who educated Grandpa Al about 1031 exchanges.
Grandpa Al decided that he would sell the shopping center as part of a 1031 exchange. Working with his real estate advisor, Grandpa Al listed the shopping center for sale, and began looking for potential replacement properties.
Because the shopping center was well-maintained, and fully occupied, there were multiple offers. Grandpa Al promptly sought referrals from his tax and legal advisors for a QI. The QI worked closely with Grandpa Al’s advisors and the closing agent to prepare for the sale of the shopping center. Grandpa Al was able to net $1,000,000 after all closing costs, and the closing agent sent this entire amount directly to Grandpa Al’s QI.
Working with his real estate advisor, Grandpa Al found four identical condo units, within walking distance of the local university. Using the $1,000,000 in exchange proceeds, and some additional cash, Grandpa Al, completed the acquisition of the four condos for $1,100,000. Grandpa Al’s QI again worked closely with his advisors and the closing agent, and Grandpa Al was able to complete the acquisition of his newly diversified investment within the exchange period.
Grandpa Al then went back to his estate planning attorney to update his Will, so that each grandchild will inherit their own individual condo unit, and have the added benefit of a step-up in basis upon Grandpa Al’s death. This means that when Grandpa Al dies, his heirs will inherit the property at the fair market value as of the date of his death. Thus, there will be no depreciation recapture or capital gains to recognize.
Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.
As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment property, and to engage the services of Accruit before closing on the sale of the relinquished property.
