The Basics of Property Exchanges…
The ability to sell one investment property and buy another without having to pay often times some rather steep federal and state taxes is probably one of the most useful and important aspects to owning commercial investment real estate. I have assisted multiple property owners through the process of completing property exchanges to avoid capital gains taxes, preserve capital, upgrade their property investments and increase cash flow. I have also accomplished several exchanges for my own account so I have personal first-hand knowledge of the process and importantly can put myself in the shoes of the investor. Additionally I had the unfortunate situation where I sold a property and really could not find any appealing exchange property investments and therefore I had to write a very painful capital gains check…it was tough so I intimately understand the process and the potential financial consequences. It is not too complicated of a process but your really have to plan and be meticulous about the process so definitely having a good financial advisor, commercial real estate broker and most importantly a experienced exchange company is important to meet the rules and regulations of this important real estate tool.
Property exchanges are especially productive for those people who have owned their properties for long periods of times and have seen their tax basis in the property go down while the market price goes up. A quick example would be if you owned a property for many years where the basis (in building/improvements) because of depreciation has diminished to $500,000 and you sell that asset for $2,500,000 where that gain of $2,000,000 can easily have a tax liability in the range of $700,000 with federal, state and depreciation recapture taxes. Ouch! An exchange often referred to as a 1031 or Starker Exchange (will explain this terminology) will allow you to buy another investment property (like-kind) of the same or equal value and not pay the tax. Many times if you are diligent and well-guided and find the right property, most likely you can substantially increase your rental income cash flow while avoiding taxes while giving you a new depreciation schedule in which to help reduce taxes on your income from the replacement property.
First a Bit of History
Like Kind property exchanges have a bit of a complicated history and the went through several iterations from when it was first federally authorized in 1921 to the modern day process which was formalized and more specifically addressed in 1954 in the 1031 section of the tax code. Certain court cases ensued (like the famous Starker Case which has served as a description of the exchange process) along with occasional dictums by the IRS since has further delineated specific rules and processes of how exchanges could occur and almost more importantly cannot occur. The Tax Reform Act of 1986 really accelerated the number of tax-deferred like-kind exchanges because it curtailed certain very liberal tax benefits of owning and selling real estate so 1031 exchanges came into the lime light as being one of the best and remaining tax benefits for property owners.
Some of the Basics
Terminology: A commercial property exchange goes by several monikers 1031 (the IRS section code) Exchange/Tax Free Exchange/Like-Kind/Starker Exchange.
Relinquished or Sold Property is referred to as the Down Leg or Relinquished and the property being purchased is referred to as the Replacement or Up Leg Property.
The Property Owner can never take ownership of any money or cash therefore a third party or Accommodator or Qualified Intermediary serves as a holder and conduit for the proceeds from the sale and then that money is used to buy the replacement property. This role is often assumed by an experienced and skilled Exchange Company many of which are affiliated with title companies and also are excellent resources for advice in addition to handling all the paperwork and making sure all the rules are followed. Getting this entity involved early in the process is very important as they can be instrumental is avoiding pitfalls, stress and making exchanges much smoother.
Knowing the Cost Basis of Your Property/Depreciation. When you purchase or if you receive a property in an inheritance there is an established basis price. When you purchase a property the basis is what you paid for the property and some selected transaction costs you can add into the value. But more importantly you need to separate the value of the land from the improvements because you can only depreciate improvements as the IRS considers the land component as an asset does not get “used up” or has a finite life like a building. This is always somewhat squishy as most buyers will want as much of the price of the asset to be vested in the improvements which gives you more liberal depreciation benefits while always being aware that this allocation is able to “pass mustard” with the IRS. A good way to establish this ratio is to look to the assessed tax value by the taxing government entity usually the county as they separate the value of the property into a value for the land and another value for the improvements. An appraisal can also suffice. Since almost every investor almost always pays a different price than the what the property is listed on the tax roles you can use the ratio of land to building values for property taxes and apply that ratio to your actual purchase price to get the value for the improvements you can now depreciate.
Depreciation: It is good to review and get a good understanding of depreciation. Because commercial real estate is considered an asset rather than an expense, the Internal Revenue Service allows property owners to decrease the value of the buildings over time to take into account the deteriorating economic life of the asset. Commercial land as mentioned in the IRS’s view does not depreciate therefore that value cannot be depreciated from a tax standpoint. So again as covered above, is important to get a good justifiable allocation of the value you attach to land and to the buildings when the asset is acquired or as often stated is “placed into sevice: The IRS allows the investor to depreciate commercial buildings (warehouses, retail center, office buildings etc.) over a 39 period and allows a more accelerated schedule for residential investments (apartment buildings, rental houses, senior living etc.) over 27.5 years. You can depreciate certain improvements you make to your property over a shorter time frames such as 15 years or even less depending on the type of improvement and explanation (often referred to as Cost Segregation) can get a bit nerdy so that is for a more detailed analysis than here. So if when you acquire an investment property like a warehouse and the buildings are allocated a value of $1,000,000, you can depreciate the building based on the 39 year schedule by $25,657.00.
Depreciation offsets income from your income property on a dollar for dollar basis. For example, if you have $100,000 of income and $30,000 in depreciation, your taxable income becomes $70,000 and if you are paying a 33% tax marginal tax rate that would result in your tax liability being reduced by $10,000 which is big deal! However if you sell your building for more than the cost minus all the depreciation you claimed, the IRS will see that the building didn’t really lose value like it was suppose to based on the deprecation. In that instance, the agency would charge you a depreciation Recapture Tax, of 25% when you sell that property. Taking the above example, if you claimed $30,000 in depreciation and building you bought for $1 million sold for a $1 million, the IRS would charge $7500.00 in depreciation recapture tax when you sell. Even more reason to look at a 1030 exchange.
Timelines: The Seller/Exchanger must identify up to three properties within 45 days of when the sale of the property closes. The Exchanger may identify more than three properties if the total fair market value of everything on the list does not exceed twice the gross sales price of the Relinquished Property. The Exchanger then has to purchase the property 180 days from when they sell their original investment. There are not options for extensions on any of these timelines.
Like Kind: The Seller/Exchanger in an exchange has to buy a like kind property which is broadly defined as “properties to be used for business or as an investment” but the code gives broad leeway for types of property that can be exchanged. For instance an Exchanger can sell an apartment building and then buy a warehouse, retail center, farm property, office building, etc. An exchanger can also buy a percentage interest in an investment property too but the all important aspect is that the property or interest being acquired has to equal or be greater in value than the Relinquished property that the Exchanger is selling. Since there is such a broad range of property exchange options it is good to get advice and input from a financial advisor or exchange company to know that the property to be acquired will be considered Like Kind.
Rules of Reinvestment: The Exchanger has to use all the cash they obtain from the Relinquished Property to purchase the Replacement Property. Exchangers can take some of the cash out of the transaction for their own use but would need to pay all the appropriate taxes on these dollars which are referred to as “boot”. The Exchanger will still need to adhere to all the other rules such as the Replacement Property being of equal or greater value etc. Another important rule is that if there is debt or a mortgage on the Relinquished property, there must be equal or greater debt on the Replacement Property.
Is your head spinning a bit? Believe it or not these are the basics and there additional variations within the 1031 process such as Reverse Exchanges where a Replacement Property is purchased before the Relinquished Property is sold; Improvement Exchanges and more, but these types of exchanges are a small percentage and needless to say more complicated portion of all 1031 Exchanges.
I hope this helps and gives a good overview and answer some standard questions about this important commercial property investment benefit. While I am not an expert I have experience in the 1031 process and can assist with laying out the basics and guiding commercial property owners through the process by directing and working closely with skilled people and firms in Exchange and Title Companies and Financing entities so that timelines are met and rules are adhered to. But more importantly, I believe I can help with understanding the investors history, motivations, financial goals, and tolerance for risk, management and property types and put the right “team” in place in order to both achieve the best possible sale of the Relinquished Property and obtain an equally or better Replacement Property Investment to help avoid often times so very stiff tax consequences and then to hopefully increase cash flow and potential property appreciation.