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1031 Exchange Investing

How Hard Is Your Investment Working

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Assessing Return on Equity

When to sell an investment property depends on many factors, including: the likelihood of future appreciation, the cash flow it produces, the ease or difficulty of managing the property, and the property’s fit in an investor’s overall investment portfolio.

A real estate investor should not overlook a simple measure to determine how hard their invested dollars are working: the property’s Return on Equity.

By analyzing return on equity, a real estate investor can compare a particular property with other potential investments in an effort to maximize the return on their investment equity.

Example: A small quad (4 units) was purchased several years ago on very favorable terms. It produces a nice cash flow that resulted in an extraordinary 20% return the first year. Even with the following assumptions, which would produce a high return on equity, the return falls to less than 5% after 7 years.

  • 10% down payment
  • 90% Loan-to-Value (LTV), 7% fixed mortgage over 30 years
  • Appreciation at an average of 4% per year
  • Annual net income increasing by 2% per year
YearValueDebt (7%)EquityEquity as
% of Value
Annual
Net Income
Return
on Equity
1300,000270,00030,00010.0%6,00020.0%
2312,000267,02044,98014.4%6,12013.6%
3324,480264,06260,41818.6%6,24210.3%
4337,459260,89076,56922.6%6,3678.3%
5350,957257,48993,46826.6%6,4946.9%
6364,995253,842111,15330.4%6,6245.9%
7379,595249,931129,66434.1%6,7565.2%
8394,779245,737149,04237.7%6,8914.6%
9410,570241,241169,32941.2%7,0284.1%
10426,993236,419190,57444.6%7,1683.7%
11444,073231,249212,82447.9%7,3113.4%
12461,836225,705236,13151.1%7,4573.1%
13480,309219,760260,54954.2%7,6062.9%
14499,522213,385286,13757.2%7,7582.7%
15519,502206,550312,95260.2%7,9132.5%
16540,282192,220348,06264.4%8,0712.3%
17561,894191,361370,53365.9%8,2322.2%
18584,370182,934401,43668.6%8,3962.0%
19607,744173,897433,84771.3%8,5631.9%
20632,054164,207467,84774.0%8,7341.8%

As evidenced in the chart above, the investor in this example has a return on equity that starts diminishing significantly after about 7 years of ownership. In order to continue obtaining a much better return on invested equity, an investor should consider exchanging this one investment property after 5-7 years and acquiring multiple replacement investment properties. Later, the investor will benefit again by exchanging these investment properties and exchanging into more (or larger) properties with leverage that will continue to produce a higher return on their equity.

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Dana Ash-McGinty

Principal Broker | Realtor® | “The Real Estate Maven”

Dana Ash-McGinty is the Principal Broker of ASH | MCGINTY, a Washington, DC Real Estate Brokerage. This real estate maven has 15+ years experience in residential, commercial and land sales in addition to multi-state residential renovation, re-zoning, and condo conversion projects. A sought after real estate authority, she has been featured on CNN and in various real estate and financial publications. Dana is married to the highly esteemed Dr. Dana W. McGinty, a Washington, DC based internal medicine physician. They are often referred to as “The Danas”.

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1031 Exchange

Five Reasons To Use a 1031 Exchange

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Investors Can Meet Multiple Objectives Under Internal Revenue Code 1031

Section 1031 tax deferred exchanges continue to increase in popularity as more investors nationwide discover the wide range of investment objectives that can be easily met through exchanging.

I. PRESERVATION OF EQUITY
A properly structured exchange provides real estate investors with the opportunity to defer 100% of both Federal and State capital gain taxes. This essentially equals an interest-free, no-term loan on taxes due until the property is sold for cash! Often the capital gain taxes are deferred indefinitely because many investors continue to exchange from one property to the next, dramatically increasing the value of their real estate investments with each exchange!

II. LEVERAGE
Many investors exchange from a property where they have a high equity position, or one that is “free and clear”, into a much more valuable property. A larger property produces more cash flow and provides greater depreciation benefits, which therefore increase the investors’ return on their investment.

III. DIVERSIFICATION
Exchangers have a number of opportunities for diversification through exchanges. One option is to diversify into another geographic region, such as ex- changing out of one apartment building in Denver, Colorado, for two additional apartments – one in Los Angeles, California, and the other in Dallas, Texas. An- other diversification alternative is acquiring a different property type, such as ex- changing from several residential units to a small retail strip center.

IV. MANAGEMENT RELIEF
Some investors accumulate several single family rentals over the years. The on- going maintenance and management of what can be a far-reaching group of properties can be lessened by exchanging these properties for one property better suited to on-site maintenance and management. Exchanging into a single apartment complex with a resident manager is a good example of this strategy.

V. ESTATE PLANNING
Sometimes a number of family members inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property, which they can either hold or sell.


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1031 Exchange Investing

What Are The Requirements For A Full Tax Referral 1031 Exchange?

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TAX DEFERRAL AND CAPITAL GAIN CALCULATIONS ARE DIFFERENT

Some real estate investors confuse what is required for full tax deferral in an exchange with calculations involved in determining their accumulated capital gain. The requirements for full tax deferral are different than the capital gain tax and/ or basis computations.

WHAT ARE THE REQUIREMENTS FOR FULL TAX DEFERRAL IN AN EXCHANGE?

If an Exchanger intends to perform an exchange that is fully tax deferred, they must meet two simple requirements:

1. Reinvest the entire net equity (net proceeds) in one or more replacement properties.

AND

2. Acquire one or more replacement properties with the same or a greater amount of debt.

An alternative approach for complete tax deferral is acquiring property of equal or greater value and spending the entire net equity in the acquisition. One exception to the second requirement is that an Exchanger can offset a reduction in debt by adding cash to the replacement property closing.

WHAT IS “BOOT?”

The term “boot” refers to any property received in an exchange that is not considered “like-kind.” Cash boot refers to the receipt of cash. Mortgage boot (also called “debt relief”) is a term describing an Exchanger’s reduction in mortgage liabilities on a replacement property. Any personal property received is also considered boot in a real property exchange transaction.

If the Exchanger receives cash or other property in addition to like-kind property, this may result in a taxable event. To determine the taxes that may be due, several steps are required. First, the Exchanger’s tax advisor must calculate the realized capital gain.

Second, the amount of “boot”, money or other property received, along with any depreciation recapture, must be determined. Finally, a tax advisor should always review the Exchanger’s specific situation to see if there are additional tax issues that may offset any current capital gain tax liabilities.


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1031 Exchange Investing

Understanding Common 1031 Exchange Terminology

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To many real estate investors, the “buzz words” often used to describe different aspects of a 1031 tax deferred exchange can be confusing.

Below are brief descriptions of commonly used exchange terminology:

ACTUAL RECEIPT: Physical possession of proceeds.

BOOT: “Non like-kind” property received; “Boot” is taxable to the extent there is a
capital gain.

CASH BOOT: Any proceeds actually or constructively received by the Exchanger.

CONSTRUCTIVE RECEIPT: Although an investor does not have actual possession of the proceeds, they are legally entitled to the proceeds in some manner such as having the money held by an entity considered as their agent or by someone having a fiduciary relationship with them. This can create a taxable event.

DIRECT DEEDING: Transfer of title directly from the Exchanger to Buyer and from the Seller to Exchanger after all necessary exchange documents have been executed.

EXCHANGER: Entity or taxpayer performing an exchange.

EXCHANGE AGREEMENT: The written agreement defining the transfer of the relinquished property, the subsequent receipt of the replacement property, and the restrictions on the exchange proceeds during the exchange period.

EXCHANGE PERIOD: The period of time in which replacement property must be received by the Exchanger; Ends on the earlier of 180 calendar days after the relinquished property closing or the due date for the Exchanger’s tax return (If the 180th day falls after the due date of the Exchanger’s tax return, an extension may be filed to be entitled to the full 180 day exchange period).

IDENTIFICATION PERIOD: A maximum of 45 calendar days from the relinquished property closing to properly identify potential replacement property or properties.

LIKE-KIND PROPERTY: Any property used for productive use in trade or business or held for investment; both the relinquished and replacement properties must be considered “like-kind” to qualify for tax deferral.

MORTGAGE BOOT: This occurs when the Exchanger does not acquire debt that is equal to or greater than the debt that was paid off on the relinquished property sale; Referred to as “debt relief”. This can create a taxable event.

QUALIFIED INTERMEDIARY: The entity who facilitates the exchange; Defined as follows: (1) Not a related party (i.e. agent, attorney, broker, etc.) (2) Receives a fee (3) Receives the relinquished property from the Exchanger and sells to the buyer (4) Purchases the replacement property from the seller and transfers it to the Exchanger.

RELINQUISHED PROPERTY: Property given up by the Exchanger; Referred to as the sale, ‘downleg’ or ‘Phase I’.

REPLACEMENT PROPERTY: Property received by the Exchanger: Referred to as the purchase, ‘upleg’ or ‘Phase II’.


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1031 Exchange Investing

An Introduction to the Benefits of 1031 Tax Deferred Exchanges

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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 earn- ing power of the deferred taxes to work for the benefit of the investor (called an “Exchanger”) instead of the government. In essence, it can be considered an interest-free loan from the IRS.

BASIC TAX EXCHANGE REQUIREMENTS

The IRS allows up to a maximum of 180 calendar days between the sale of the relinquished property and the purchase of the replacement property. Within the 180 day “exchange period,” the investor must also properly identify suitable replacement properties within 45 calendar days of closing on the sale of the relinquished property. There are a number of requirements which need to be met to qualify for tax deferral under the tax code:

Requirement #1: Both the “relinquished” and “replacement” properties must be held for investment or used in a business. The IRS uses the term “like-kind” to describe the type of properties that qualify. Any property held for investment can be exchanged for any other “like-kind” property held for investment. This definition covers a vast variety of developed and undeveloped real estate. Properties which are clearly not like-kind are an investor’s primary residence or property “held for sale.”

The relinquished and replacement properties need not have identical functions (i.e. both be residential rentals or commercial strip centers). The key issue is that the Exchanger can substantiate that both properties were “held for investment.”

Requirement #2: The IRS requires an investor to identify the replacement prop- erty(s) within 45 days from closing on the sale of a relinquished property. The 45 day Identification Period begins on the closing date, and the replacement prop- erty(s) must be properly identified in a letter signed by the Exchanger. Exchang- ers have a number of ways to properly identify properties. They may identify up to three replacement properties without regard to their total fair market value (Three Property Rule). Alternatively, they can identify an unlimited number of replacement properties, if the total fair market value of all properties is not more than twice the value of the property sold (200% Rule). An Exchanger can not meet either of these rules if they acquire 95%of the aggregate fair market value of all identified replacement properties.

Requirement #3: Close on the replacement property by the earliest of either: 180 calendar days after closing on the sale of the relinquished property or the due date for filing the tax return for the year in which the relinquished property was sold (unless an automatic filing-extension has been obtained). Example: If an Exchanger closes on the relinquished property on December 27, the exchange period will end on April 15 (assuming this is the due date for their tax return). In this case, they would have to close on the replacement property (or file the appropriate extension) by April 15. Exchangers may choose to close both transactions within a shorter period of time, thereby avoiding the potential hardship of the 45/180 day time limits.

Requirement #4: The most common exchange format, the delayed exchange, requires investors to work with an IRS-approved middleman called a “Qualified Intermediary.” The Qualified Intermediary documents the exchange by preparing the necessary paperwork (Exchange Agreement and other documents), holding proceeds on behalf of the Exchanger, and structuring the sale of the relinquished property and purchase of the replacement property.

Note: To defer all capital gain taxes, an Exchanger must buy a property or properties of equal or greater value (net of closing costs), reinvesting all net proceeds from the sale of the relinquished property. Any funds not reinvested, or any re- duction in debt liabilities not made up for with additional cash from the Ex- changer, is considered “boot” and is taxable. Example: Stewart sells his duplex, which he held for investment, for $160,000. A hundred calendar days later he closes on a different duplex, which he will hold for investment, for $110,000. Stewart receives the $50,000 in excess funds for his child’s education. Stewart must pay capital gain taxes on $50,000. (In this example, Stewart chose to take some money out of his exchange and pay the capital gain taxes.)

WHEN ARE CAPITAL GAIN TAXES PAID?

Maybe never. Many investors mistakenly believe they will “have to pay the taxes sometime” so they might as well just sell. Quite often, this is a bad invest- ment decision. The tax on an exchange is deferred into the future and is only recognized when an investor actually sells the property for cash instead of performing an exchange. Investors can continue to exchange properties as often and for as long as they wish, thus moving up to better investments and putting off the taxes for many years.


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