1031 Tax-Deferred Exchange Information
What is a 1031 Tax Deferred Exchange?
The IRS Tax Code allows you to sell one or more investment properties and buy one or more properties through a qualified intermediary (QI). “The 1031 Exchange is a tax deferral strategy for highly appreciated real estate”. The seller cannot touch or control the funds. The basic rules are that: new property(s) have a price equal to or greater than the property(s) being sold, all of the cash from the sale must go to the purchase, and title must be held in the same name as the property sold. The IRS has three basic rules regarding the identification of the replacement property: You may identify three properties of any value, or you may identify any number of properties if the total fair market value of what is identified does not exceed 200% of the sale price of the sold property, or if you identify more properties than are permitted under the above rules, you must acquire 95% of what was identified. The IRS has established an identification period for the new properties. You have 45 days from the closing date of the sold property to identify the potential new properties. You have 180 days to close the replacement property from the date of closing of the original sold property.
DISCLAIMER: It is imperative that you seek the advice of a CPA or tax attorney to determine all tax aspects of an exchange.
Why Exchange into a 1031 Tax Deferred NNN Real Estate Investment?
- Your existing property is highly appreciated.
- You have fully depreciated the property
- The property is too management intensive
- The property is not providing enough cash flow
With the price of apartment buildings today, NOW is the best time to think about selling your labor intensive apartment building and purchase a non-labor intensive single tenant, NNN building. Is it time to maximize your income return on investment properties?
- Increase your cash flow and earnings. Returns on apartment buildings in B or better locations are in the 2-4% range; where we can deliver Single Tenant NNN properties for 7-9% (+-) rates.
- Eliminate the day to day responsibilities of management or the cost of professional management.
- Stabilize property occupancies.
- Guaranteed rental increases.
- National credit tenants
- Increase in depreciation basis.
Please see the Market Evaluation of your property and the comparison worksheet for a detailed analysis of a property that fits your financial position based on your current investment property.
It is better to own an asset class like commercial real estate that has the potential to pay a higher monthly cash flow and has a continuing good appreciation potential rather than holding onto residential income rentals, which can yield far less monthly cash flow and have an uncertain appreciation potential for the next several years.
As an investor, if you have ever wanted to do a 1031 exchange but decided to wait until the real estate market peaked, you’re not alone. For roughly the last year and a half, many potential 1031 exchangers have been taking their income-producing properties off the market, waiting for the real estate market to get stronger and sell their property for higher profit margins. In theory, the waiting strategy makes sense. But in reality, it’s nothing more than a costly mistake.
Thanks to the credit tenant (NNN) investment option, investors can sell their income-producing property at a less-than-peak selling price, do a 1031 exchange, and still potentially make more money than if they had waited for the market to turn around. Don’t lose out. Instead, take the following two scenarios into consideration when considering the cost of waiting.
SCENARIO 1
Imagine that you own a residential income property that you bought 25 years ago for $100,000. Today, it is worth $700,000 when the market is down and $750,000 when the market is up. Many investors will naturally want to wait for the market to peak so they can reap the extra $50,000 of appreciation. If you wait, you will continue to make roughly $14,000 a year in cash flow from this income-producing property, assuming the property is netting $1,200 a month (or 2% on the appreciated equity).
However, if you purchase a (NNN) commercial property, you would receive $42,000 a year, assuming a 6% yield on $700,000 of equity. The difference between $42,000 (from the commercial property) and the $14,000 (from the residential property) is $28,000. This means that in less than two years you can recoup the $50,000 of “lost” appreciation just by earning a standard (NNN) cash flow.
SCENARIO 2
On July 10, 2006, the Wall Street Journal ran an article by Jennifer S. Forsyth titled “Commercial Real Estate Maintains Its Strength.” It is said that despite a cooling housing market, over-building and oversupply has happened in the residential market and not in the commercial market. Assuming this means that the residential income market will remain flat for, say, three years, you as an investor would receive no appreciation during that time if you held on to that residential income property waiting for the market to turn around.
Conversely, because the commercial market is in balance, we can assume a commercial property can continue to appreciate at 3% per year. So, if we take a typical (NNN) commercial property that is 50% leveraged, a 3% appreciation on the property would be a 6% appreciation on your equity. That 6% appreciation on $700,000 of equity is $42,000 per year. By adding that $42,000 of appreciation to the $28,000 difference between cash flows, you end up ahead by $70,000 per year. Over three years, this equates to a gain of $210,000 – an amount more than four times better than the $50,000 of “lost” appreciation.
If you have decided not to do a 1031 exchange in hopes of the residential market turning around, I encourage you to do the math. Not doing so may cost you more than you think.
IMPORTANT DISCLOSURES:
The direct or indirect purchase of real property involves significant risks, including market risks and risks specific to a given property. There are a number of significant tax risks and tax issues involved with the purchase of real property. Investors should consult their own tax advisors and legal counsel.
